The Labour leader is a supporter of a "homeland for the Jewish people" but has made clear he does not give blanket backing to the actions of the Israeli government.
Miliband, who is of Jewish descent but an atheist, made his strongest criticism yet during a visit to the Middle East, describing the policy as "wrong and illegal".
He spoke out after visiting the Khan al-Ahmar Bedouin camp on the West Bank where families are facing forced displacement if Israeli settlements go ahead.
The Labour leader said: "What I have seen today shows that the expansion of Israeli settlements on the Palestinian West Bank is not only wrong and illegal but represents a mortal threat to the two-state solution and to a successful outcome of the peace process.
"If we are going to have a viable, democratic Palestinian state the more we see an expansion of settlements the more it becomes difficult to construct this state."
He is on the last leg of a three-day visit and stayed overnight in Ramallah, in central West Bank, last night - the first leading British politician to be able to do so as a result of improved security conditions.
Miliband has already held talks with Israeli PM Benjamin Netanyahu and will meet with Palestinian president Mahmoud Abbas before he leaves tomorrow.
His visit comes just one month after Prime Minister David Cameron's Middle East trip where he pushed for the premiers to agree an outline deal.