The text was approved by a parliamentary committee today morning, despite a spate of amendments by the opposition, and is scheduled for debate by MPs in the afternoon.
Lawmakers are expected to vote on it tomorrow, with adoption seen as likely.
Backed by the country's right-wing government, the bill has alarmed the international community and supporters of an independent Palestinian state.
The Palestine Liberation Organisation labelled the bill a "declaration of war", and called on the international community to intervene.
Around 2,000 Israelis, including many settlers, protested outside Israel's parliament today in support of the law, an AFP correspondent said.
The law would legalise at least 3,921 homes built in contravention of Israeli law, according to the anti-settlement organisation Peace Now.
Israeli law distinguishes between settlements it considers legal and so-called "outposts", but the bill would legalise 54 of the latter, Peace Now said.
The owners of the land would be compensated financially or with land elsewhere.
Even if passed by parliament, the bill could still be struck down by the Supreme Court.
In a statement, Peace Now said the bill would "stain Israel's law books".
"The draft law will practically allow the government and private individuals to steal lands of Palestinians without any legal implications," it said.
International law considers all Israeli settlements in the West Bank, the Palestinian territory occupied since 1967, to be illegal, and they are seen as a major obstacle to peace between Israelis and Palestinians.
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