Qassam rockets are frequently fired from Gaza into southern Israel
Israeli officials told the BBC fuel and electricity supplies could be targeted, but not water, food or medicine.
The militant group Hamas, which controls Gaza, said such a move would be considered a declaration of war.
In Jerusalem, US Secretary of State Condoleezza Rice also said the US considered Hamas a "hostile entity".
But she added that the US "would not abandon the innocent Palestinians" of Gaza.
I call for Israel to reconsider this decision
Ban Ki-moon
UN Secretary General
Ms Rice arrived in Jerusalem on Wednesday for talks about re-starting the Middle East peace process.
Israeli public pressure for retaliation has grown since a rocket fired from Gaza hit an army base last Tuesday, injuring 69 troops.
Palestinian militant groups say the rocket fire is a response to Israeli military action in Gaza and the West Bank.
International law
Israeli Prime Minister Ehud Olmert's office said his security cabinet had approved the "hostile entity" classification on Wednesday morning.
It is a declaration of war and continues the criminal, terrorist Zionist actions against our people
Fawzi Barhoum
Hamas spokesman
Israel's limited options
"Additional restrictions will be imposed on the Hamas regime, limiting the transfer of goods to the Gaza Strip, cutting back fuel and electricity, and restricting the movement of people," a statement said.
It said the sanctions would be implemented "following a legal review" to examine the legal and humanitarian consequences.
Israeli officials reportedly hope the new measures will put pressure on Hamas, which ousted its rivals Fatah to seize control of Gaza in June, to halt rocket attacks on southern Israel.
A spokesman for Hamas in Gaza, Fawzi Barhoum, condemned the decision.
"It is a declaration of war and continues the criminal, terrorist Zionist actions against our people," he said.
"They aim to starve our people and force them to accept humiliating formulas that could emerge from the so-called November peace conference," he added, referring to the US-sponsored talks expected later this year.
The Palestinian Information Minister, Riyad al-Malki, said the Palestinian Authority would ask the US to "pressure Israel to refrain from taking such action".
Correspondents say that by formally declaring Gaza "hostile", Israel could argue that it is no longer bound by international law governing the administration of occupied territory to supply utilities to its 1.5 million inhabitants.
But the current position is that, under international law, Israel remains legally responsible for the coastal strip, despite withdrawing two years ago, because it still controls Gaza's borders, airspace and territorial waters.
An Israeli government source told the BBC that Israel believed the decision was entirely legal in terms of Israeli law, which Israelis "correlate with international law".
But UN Secretary General Ban Ki-moon urged Israel to reconsider its decision.
"Such a step would be contrary to Israel's obligations towards the civilian population [of Gaza] under international humanitarian and human rights law," he said.
The Israeli move will only be seen by Palestinians as a form of collective punishment and risks consolidating support for Hamas in Gaza, BBC diplomatic correspondent Jonathan Marcus says.
Two-state solution
Ms Rice is in the Middle East for talks ahead of the peace conference.
The US is supporting Mahmoud Abbas while isolating Hamas
She is due to meet Mr Olmert and the Palestinian Authority President Mahmoud Abbas.
With US encouragement, the two recently held a series of face-to-face meetings.
After their last meeting on 10 September, both leaders reaffirmed their commitment to a two-state solution and agreed to set up negotiating teams to discuss some of the disputed issues.
Map of the Gaza Strip.
The Israeli government has declared the Gaza Strip an "enemy entity" due to the continued firing of rockets into Israel from Gaza. Gaza's ruling Hamas party has stated that it considers the announcement a "declaration of war." 

The definition means that Israel could stop supplying Gaza with fuel, electricity and other commodities.

"Following extensive legal consultations, Israel has decided to declare Gaza as a hostile entity, with all the international implications. This move will prepare the groundwork for sanctions against Gaza, such as the interruption of gas, electricity and water supply, which will occur in a gradual process," said an unnamed Israeli government official.

Ehud Barak, the Israeli Minister of Defense said the "objective is to weaken Hamas" , while Hamas spokesman Fawzi Barhoum suggested "...they aim to starve our people and force them to accept humiliating formulas that could emerge from the so-called November peace conference," 

Barak also said that Israel is considering a military operation in the Gaza Strip saying that "every day that passes brings us closer to an operation in Gaza."

The democratically-elected Hamas party, and its militant wing the Izz ad-Din al-Qassam Brigades, have been labeled "foreign terrorist organization"s by a number of bodies including the European Union, Israel, the United States, Canada and others.