The comments followed days of low-level unrest at the city's most sacred shrine. The violence has added to regional tensions fueled by stalled peace efforts, Israeli construction in Jewish settlements and a U.N. report accusing Israel of committing war crimes in the Gaza Strip.
Late Sunday, Palestinian President Mahmoud Abbas accused Israel of "Judaizing" Jerusalem and undermining Palestinian claims to the city.
In an about-face, Abbas also announced he would push for a vote in the U.N. Human Rights Council, which commissioned the Gaza report, to refer it to the U.N. General Assembly — a move that could ultimately lead to war crimes proceedings against Israel.
Israel put thousands of police on high alert in Jerusalem last week after several days of scuffles between police and Palestinians around the disputed hilltop compound known to Jews as the Temple Mount and to Muslims as the Noble Sanctuary.
The competing claims to the site — home to the biblical Jewish Temples and to the Al Aqsa Mosque — is seen as the most intractable issue in the Israeli-Palestinian conflict.
Arab protests around the site were fed in part by rumors by local Muslim leaders that Israel was digging tunnels under the mosque and planning to take over the site.
"I wish to clarify. This is an unfounded lie," Netanyahu told his Cabinet on Monday.
"Last week, extremists tried to undermine the peaceful life in Jerusalem," he said. "I appreciate the fact that the vast majority of Arab Israeli citizens did not follow the provocations and did not let the extremists exploit the lies." He also appealed for coexistence with Israel's Arabs, who make up about one-fifth of Israel's 7 million citizens.
Netanyahu's comments were his first on the Jerusalem unrest, which has added to growing mistrust of the Israeli leader in the Arab world.
Israel and the Palestinians both claim Jerusalem.
Netanyahu insists Israel will retain control over the entire city, including the eastern sector it captured and annexed in 1967.
The Palestinians claim east Jerusalem, home to the most sensitive religious sites, as the capital of a future independent state.