A US abstention paved the way for the 15-member council to approve the resolution, with 14 votes in favour, prompting applause in the council chamber. The action by President Barack Obama's administration follows growing US frustration over the unrelenting construction of Jewish settlements on land Palestinians want for a future independent state.
"Israel rejects this shameful anti-Israel resolution at the UN and will not abide by its terms," Prime Minister Benjamin Netanyahu, who has encouraged the expansion of Jewish settlements in territory captured by Israel in a 1967 war with its Arab neighbours, said in a statement.
The US action just weeks before Obama ends eight years as president broke with the long-standing American approach of shielding Israel, which receives more than $3 billion in annual US military aid, from such action. The United States, Russia, France, Britain and China have veto power on the council.
The resolution, put forward by New Zealand, Malaysia, Venezuela and Senegal a day after Egypt withdrew it under pressure from Israel and Trump, was the first adopted by the council on Israel and the Palestinians in nearly eight years.
The US abstention was seen as a parting shot by Obama, who has had an acrimonious relationship with Netanyahu and whose efforts to forge a peace agreement based on a 'two-state' solution of creating a Palestinian state existing peacefully alongside Israel have proven futile.
Obama also faced pressure from US lawmakers, fellow Democrats as well as Republicans, to veto the measure, and was hit with bipartisan criticism after the vote.
Trump, who takes office on January 20, took the extraordinary step by a US president-elect of personally intervening in a sensitive foreign policy matter before taking office, speaking by telephone with Netanyahu and Egyptian President Abdel Fattah al-Sisi before Egypt, another major US aid recipient, dropped the resolution.
Trump wrote on Twitter after the vote: "As to the UN, things will be different after January 20th."
"There is one president at a time," Ben Rhodes, White House deputy national security adviser, told reporters, dismissing Trump's criticism.
Outgoing UN Secretary General Ban Ki-moon welcomed the resolution. Russian UN Ambassador Vitaly Churkin called on Israel to "respect international law."
But Netanyahu said, "At a time when the Security Council does nothing to stop the slaughter of half a million people in Syria, it disgracefully gangs up on the one true democracy in the Middle East, Israel, and calls the Western Wall 'occupied territory.'"
Israel for decades has pursued a policy of constructing Jewish settlements on territory captured by Israel in a 1967 war with its Arab neighbours including the West Bank, Gaza and East Jerusalem. Most countries view Israeli settlement activity in the West Bank and East Jerusalem as illegal and an obstacle to peace. Israel disagrees.
The resolution demanded that Israel immediately and completely cease all settlement activities in the occupied Palestinian territory, including East Jerusalem and said the establishment of settlements by Israel has no legal validity and constitutes a flagrant violation under international law.
The White House said that in the absence of any meaningful peace process, Obama made the decision to abstain. The last round of US-led peace talks between the Israelis and Palestinians collapsed in 2014. The Palestinians want an independent state in the West Bank, Gaza and East Jerusalem.
"We could not in good conscience veto a resolution that expressed concerns about the very trends that are eroding the foundation for a two-state solution," Rhodes said.
American UN ambassador Samantha Power said the United States did not veto it because the resolution reflects the facts on the ground and is consistent with US policy across Republican and Democratic administrations.
Successive US administrations of both parties have criticised settlement activity but have done little to slow their growth.
The Obama administration has called settlement expansion an 'illegitimate' policy that has undermined chances of a peace deal.
The Security Council last adopted a resolution critical of settlements in 1979, with the United States also abstaining.
The passage of Friday's resolution changes nothing on the ground between Israel and the Palestinians and likely will be all but ignored by the incoming Trump administration.
But it was more than merely symbolic. It formally enshrined the international community’s disapproval of Israeli settlement building and could spur further Palestinian moves against Israel in international forums.
Trump is likely to be a more staunch supporter of Netanyahu's right-wing policies. He has picked a hardline pro-Israel ambassador and vowed to move the US Embassy from Tel Aviv to Jerusalem, in what would be a major reversal of long-standing American policy.
A spokesman for Palestinian President Mahmoud Abbas said in a statement published by the official Palestinian news agency Wafa that the UN action was a big blow to Israeli policy, a unanimous international condemnation of settlements and a strong support for the two-state solution.
"This is a day of victory for international law, a victory for civilised language and negotiation, and a total rejection of extremist forces in Israel," Chief Palestinian Negotiator Saeb Erekat told Reuters.
Israel's UN ambassador, Danny Danon, said he had no doubt the incoming Trump administration and Ban's successor as UN chief, former Portuguese Prime Minister Antonio Guterres will usher in a new era in terms of the UN's relationship with Israel.
After the vote, Netanyahu instructed Israel's ambassadors in New Zealand and Senegal to return to Israel for consultations. He also ordered the cancellation of a planned visit to Israel by Senegal's foreign minister and the cancellation of all aid programs to Senegal.