Israel has suspended new rules that would have had the effect of separating Palestinian and Jewish passengers on buses travelling to the West Bank.
The defence ministry launched a three-month trial on Wednesday morning, but within hours Prime Minister Benjamin Netanyahu said it was "unacceptable".
Groups representing Jewish settlers have been campaigning for segregated travel on security grounds.
But human rights groups described the measures as shameful and racist.
About 500,000 Jews live in more than 100 settlements built since Israel's 1967 occupation of the West Bank and East Jerusalem. The settlements are considered illegal under international law, though Israel disputes this.
Palestinians travelling to work in Israel were urged to board special buses in 2013
The travel rules put in place by the Israeli defence ministry for a trial period on Wednesday would have applied to the tens of thousands of Palestinian workers who legally travel through checkpoints to work in Israel every day.
Instead of being free to travel home from Israel on any bus heading to the West Bank, the workers would have been required to return only on buses which went back to the checkpoint where they entered Israel - thus denying them access to shared buses which do not go to the checkpoints.
The effect would have been to segregate Jewish and Palestinian passengers onto different buses, says the BBC's Kevin Connolly in Jerusalem.
The leader of Israel's opposition, Yitzhak Herzog of the Zionist Union, wrote on his Facebook page that the move was "a needless humiliation, a stain on the country's face and citizens", and had nothing to do with security.
Tens of thousands of Palestinians pass through checkpoints to work in Israel every day
Yariv Oppenheimer, from the campaign group Peace Now, said: "When something looks like apartheid and smells like apartheid, then it's apartheid."
Within hours on the trial beginning, Mr Netanyahu had informed Defence Minister Moshe Yaalon that it was "unacceptable" and should be suspended, a senior official in the prime minister's office told the BBC.
Our correspondent says it appears Mr Netanyahu over-ruled Mr Yaalon after detecting the danger of damage to Israel's international reputation.
It is hard to see how it could be reinstated in its current form, he adds.
Many Jewish settlers who use the same buses to travel back to their own communities argue that allowing Palestinian passengers onto the buses creates a security risk.
Mr Yaalon has previously said: "Twenty Arabs on a bus with a Jewish driver, two or three passengers and one soldier with a gun is a set-up for an attack."
However, the former head of the Israeli military's Central Command, Maj Gen Nitzan Alon, said that he did not consider Palestinian workers to be a threat.
In a separate development on Wednesday, Israeli police said they had shot dead a Palestinian man in East Jerusalem after he swerved his vehicle towards a group of police officers. Two officers were slightly injured, and taken to hospital.
Following the shooting in the al-Tur district, Palestinians threw rocks at police. One eyewitness said the driver had tried to swerve to avoid hitting pedestrians.