The sanctions were launched alongside France and Canada, who in a joint statement with the UK said the action “marks a further turning point in our approach to protecting the two-state solution”.
Settlements are illegal under international law, and there has been a rise in violence towards Palestinians in the West Bank by settlers in recent months.
In a statement to MPs, Miliband said: “The British government agrees that there is ethnic cleansing of Palestinians in areas of the West Bank, perpetrated by settler terrorists.
“And all too often the Israeli government has turned a blind eye to this and worse, members of it have made statements and taken actions to support the forced displacement of Palestinians.”
He said ethnic cleansing was defined by the UN as a “purposeful policy designed by one ethnic or religious group to remove by violent means another ethnic or religious from certain areas”.
Miliband said the official view of the government was that the Israeli occupation of the West Bank was unlawful because of the “entrenchment of its control, its intention to extend permanent sovereignty, and its expansionist agenda via illegal settlements”.
He said this position, which is in line with a 2024 advisory opinion from the International Court of Justice, should be reflected in the UK’s “economic relationship” with the occupied West Bank.
As a result, over the next six to nine months, the UK will introduce “a new comprehensive sanctions regime”, he said.
The foreign secretary also announced a ban on advertising illegal West Bank settlements in the UK.
“The sanctions regime will target illegal settlements and settlement expansion, not Israel,” Miliband added.
Later on Tuesday, Prime Minister Andy Burnham said the targeted measures were “aimed not at the Israeli people, but in support of the two-state solution”.
Announcing the closure of the UK consulate, which represents the UK government in Jerusalem, West Bank and Gaza, Israel’s Foreign Minister Saar said at a press conference: “We know that we have many friends in Britain.
“Unfortunately, we have a hostile Labour government that is consistently operating against the State of Israel, and it has left us no choice but to respond to its hostile actions.”
He added that 11 UK MPs, including Jeremy Corbyn, Diane Abbott and all five sitting Green Party MPs, would be banned from entering Israel, accusing them of “antisemitic and anti-Israel activity”.
The UK also issued a joint statement with 11 other countries; France, Canada, Denmark, Spain, Finland, Ireland, Iceland, Norway, Poland, Portugal and Sweden.
It said the group was unequivocally committed to the two-state solution and would introduce national measures or support European restrictions on trading goods with West Bank settlements.