A report by the British charity says the year-long boycott of the Hamas-led government has seen an increase in poverty in Gaza and the West Bank.
Oxfam said poverty levels had risen by 30%, basic services faced meltdown and factional violence plagued the streets.
This situation, it says, may prevent a two-state solution with Israel.
Oxfam said the EU should not miss what it called an “opportunity to restore the faith of the Palestinian people in the Europeans` role as an honest broker” of the Middle East peace process.
“International aid should be provided impartially on the basis of need, not as a political tool to change the policies of a government,” said Oxfam International Executive Director Jeremy Hobbs.
“With Palestinian institutions collapsing and insecurity growing, the resumption of international aid to the Palestinian Authority is a necessary step to preventing further suffering and securing a just and lasting settlement on the basis of international law,” he said.
The EU was the biggest aid donor to the Palestinian government until the Hamas militants came to power in March 2006.
Since then, the EU has redirected its aid, worth 700m euros (US $943m) in 2006, through a special mechanism to help the neediest people while bypassing the government to avoid contact with Hamas.
This week the new Palestinian Finance Minister, Salam Fayyad, told EU leaders in Brussels that his government urgently needed a resumption of funds.
Mr Fayyad said that one billion euros ($1.35bn; £681m) in aid was still needed this year in order to avert a deepening of the crisis.
Israel suspended the transfer of taxes to the Hamas-led government because of the party`s refusal to recognise the Jewish state, renounce violence and respect past political agreements.
The international community took a similar position, though the formation of a national unity government last month has opened the way for some countries to deal directly with non-Hamas ministers.
OXFAM FINDINGS: – Four out of five of 677 families saw a drop in their income following the boycott; – 50% of all the families reported losing more than 50% of their income; – 90% of the managers running schools, hospitals and water services across the West Bank and Gaza said services undermined.
BBC News, 13.04.2007