Germany has reportedly threatened to halt the delivery to Israel of a sixth Dolphin class submarine, supposedly capable of firing nuclear-tipped missiles at Iran, in protest against plans to build 1,100 homes for Jewish settlers in an East Jerusalem suburb.

Israel has three Dolphins operational and is expecting to take delivery of two advanced variants over the next two years, so the loss of the sixth boat, if that happens, shouldn't be catastrophic.

But in political terms, it was have a serious impact on Israel's relations with a key European arms supplier at a time when the Jewish state is facing growing international isolation over its military actions against the Palestinians and its refusal to relinquish Jewish settlements in the West Bank.

German newsmagazine Der Spiegel on Monday cited German government sources as confirming that the government of German Chancellor Angela Merkel had conveyed the threat to Israel.

It gave no details but said the move was in response to the right-wing government of Prime Minister Binyamin Netanyahu to allow construction of a Jewish settlement in the Gilo district of East Jerusalem captured from Jordan in the 1967 Middle East war.

Netanyahu's decision, rebuffing U.S. calls for a settlements freeze, is a major setback for already faltering peace efforts with the Palestinians.

If Berlin decides not to deliver the new submarine, it could indicate that Germany was backing off its long-running policy of providing Israel with heavily subsidized weapons as part of a 1953 reparations agreement linked to the Holocaust of the Nazi era.

Blocking the sale of the Dolphin, currently under construction at the Howaldtswerke-Deutsche Werft AG shipyard in Kiel on the Baltic Sea, could encourage other European defense suppliers to follow suit.

That would reflect widespread EU criticism of Netanyahu's government for its refusal to make any accommodation with the Palestinians over the West Bank.

Halting settlement expansion could open the door to a peace agreement, effectively ending the 63-year-old Middle East conflict.

Germany donated the first two Dolphins in the late 1990s, as part of the reparations agreement, and half the $700 million cost of the third boat. In 2006, Israel ordered two more Dolphins, with the Germans agreeing to pick up one-third of the total cost of $1.27 billion.

After Israel ordered the sixth of the diesel-electric subs built by HDW, the shipbuilding division of the German steelmaking giant ThyssenKrupp, Netanyahu asked Berlin to pay one-third of $700 million-$1 billion cost of the boat, more advanced than its predecessors.

Berlin, affected by the global economic downturn, balked at that. German opposition parties have long opposed the sale of weapons by German companies to countries in conflict zones.

But in the summer, Der Spiegel noted, Merkel's government "approved $189 million in funding to assist Israel with the purchase of a sixth Dolphin over the next four years. Now, however, that deal … is in jeopardy."

However, the increasingly contentious sale of the sixth Dolphin could be salvaged by the German defense industry's increasing focus on exports to compensate for shrinking defense spending at home, a situation afflicting arms manufacturers in the United States, Europe and Russia.

Strict regulations concerning arms sales abroad are increasingly being sidestepped by Germany's arms industry, such as the recently approved sale to Saudi Arabia of some 260 Leopard 2A7+ main battle tanks built by Krauss-Maffei Wegmann of Munich.

That contract is worth about $2 billion.

The decision by Germany's Federal Security Council, which rules on what weapons systems can be exported, has stirred considerable controversy in Germany.

The tank sale would have been impossible a few years ago but the council used a loophole in the export regulations by declaring it exceptional because it involved "special interests of foreign policy."

"Growth doesn't come from Europe anymore," observed Stefan Zoller, head of Cassidian, a defense company that's an offshoot of the giant EADS European conglomerate.

It won a $2 billion contract to construct a security system along Saudi Arabia's 5,600 miles of borders as well as air and sea ports.

Der Spiegel says Germany ranks third behind the United States and Russia among the world's leading arms suppliers.

It noted that "almost 1-10th of all the money generated by global weapons exports ends up in the pockets of the German defense industry."