She framed her message as friendly advice to an increasingly isolated Prime Minister Netanyahu, whose move has drawn international condemnation, including from European states and Israel's closest ally the United States.
Germany, which is usually supportive of Israel, has said the plan - announced by Israel a day after the UN General Assembly's de facto recognition of Palestinian statehood - risks extinguishing hopes for a two-state solution.
At a joint news conference with Netanyahu in Berlin, Merkel was more muted in her criticism than her government has recently been, although she acknowledged they had discussed the housing plan over dinner on Wednesday.
"Of course we spoke about it ... we agreed to disagree," she said.
"Israel decides for itself, it is a sovereign state. All we can do as a partner is give our opinion and our evaluation. The aim is clear ... it is for a two-state solution."
Palestinians say the new settlements on land they seek for their state could bisect the West Bank and cut them off from Jerusalem, their would-be capital.
"We in Germany believe the work on a two-state solution must be continued ... We must keep trying to come to negotiations and one-sided moves should be avoided," Merkel added.
Netanyahu, who had told German newspaper Die Welt he was disappointed that Germany had abstained in the UN vote rather than vote with Israel, brushed aside the issue of settlements.
He told Merkel he had no doubt whatsoever of her commitment to the security and well-being of Israel and criticized what he called a misconception in Europe that settlement-building was preventing peace.Disagreement
"I don't think we have lost Europe," he said. "There is obviously a difference of view in Europe, on the issue of settlements ... it is not the root cause of our conflict."
Disagreement over settlement building has tested relations behind the scenes between Germany and Israel for several years.
Netanyahu said he remained committed to a two-state solution and was willing to hold negotiations with the Palestinians.
"The most important thing is that peace will not be decided in the UN in New York and not in Europe. It can only be advanced in Jerusalem and Ramallah," he said.
Netanyahu, favored to win a Jan. 22 general election with the backing of right-wing voters, has rejected calls by the United States and Europe to reverse course over settlements.
US-sponsored Israeli-Palestinian talks collapsed in 2010 in a dispute over settlement-building. All settlements are illegal under international law.
Germany nurtures strong relations with Israel and feels a special responsibility for its security because of the Nazi-perpetrated Holocaust.
Many Israeli ministers joined Netanyahu in Berlin on Thursday for consultations with their German counterparts on a broad range of issues, though to Berlin's chagrin Foreign Minister Avigdor Lieberman withdrew from the visit.
BERLIN (Reuters) -- German Chancellor Angela Merkel urged Israeli leader Benjamin Netanyahu on Thursday to avoid "one-sided moves," amid uproar over Israeli plans to build 3,000 settler homes in a highly sensitive area of the West Bank.