The US has announced that it will withhold more than half of the funding it provides for a UN agency that supports Palestinians, about two weeks after President Donald Trump threatened to pull funding for the group.

Washington will withhold USD 65 million out of its scheduled USD 125 million payment to the UN Relief Works Agency (UNRWA), which provides humanitarian aid, education, social services and medical care to Palestinian refugees in the West Bank, Gaza Strip, Jordan, Syria and Lebanon, CNN reported.

Trump had said that the US could cut aid if Palestinians rejected peace efforts with Israel.

The decision drew condemnation from Palestinians and praise from Israel. The UN officials expressed deep concern and refugee groups worried about the humanitarian impact, particularly the potential for further destabilisation of a region already reeling from conflict in Syria.

State Department spokeswoman Heather Nauert said on Tuesday that the move had nothing to do with "punishing" the Palestinians for their refusal to enter into negotiations with Israel, or their decision to push for a UN vote that resulted in global condemnation of the US decision to unilaterally recognize Jerusalem as Israel's capital.

"This is not aimed at punishing anyone," Nauert said on Tuesday as she outlined the Trump administration's decision to release USD 60 million in funding for the agency, while indefinitely withholding another USD 65 million.

The decision came two weeks after Trump complained that Washington receives "no appreciation or respect" in return for its aid.

"The move will have devastating consequences for vulnerable Palestinian refugees across the Middle East, including hundreds of thousands of refugee children in the West Bank and Gaza, Lebanon, Jordan and Syria," said Jan Egeland, former Norwegian Foreign Minister and former UN undersecretary general for humanitarian affairs and emergency relief coordinator.

UN Secretary General Antonio Guterres said he was "very concerned" about the impact on the region.

Nauert said the money was being withheld because the US would like to see reforms at UNRWA and added that Washington would also like to see other countries contribute more to the relief agency, which was founded in 1949 after the Arab-Israeli war, to deal specifically with Palestinian refugees.

PLO Executive Committee member Hanan Ashrawi slammed the decision to withhold the funds, saying it targeted "the most vulnerable segment of the Palestinian people", adding that it "will generate further instability throughout the region".

Israel's Ambassador to the UN, Danny Danon, praising the move said: "UNRWA has proven time and again to be an agency that misuses the humanitarian aid of the international community and instead supports anti-Israel propaganda, perpetuates the plight of Palestinian refugees and encourages hate."