The law passed by 60 votes to 52.
It states that the original Palestinian landowners will be compensated with money or alternative land.
The new US President Donald Trump has taken a softer stance on Israel's settlements than his predecessor, Barack Obama, despite widespread international opposition.
Emboldened by the new US administration, Israel has undertaken a series of pro-settlement moves in recent weeks, including the approval of thousands of homes.
Those were punctuated by Israeli security forces last week evicting hundreds of hardline Jewish settlers from Amona, an illegal outpost of on the occupied West Bank.
The move followed years of political controversy over the outpost, which is built on private Palestinian land.