The resolution called for negotiations to be based on territorial lines that existed before Israel captured the West Bank, East Jerusalem and the Gaza Strip in the 1967 Middle East war. It also called for a peace deal within 12 months.
Even if the draft had received the minimum nine votes in favor, it would have been defeated by Washington's vote against it. The United States is one of the five veto-wielding permanent members.
There were eight votes in favor, including France, Russia and China, two against and five abstentions, among them Britain. Australia joined the United States in voting against the measure.
US Ambassador to the United Nations Samantha Power defended Washington's position against the draft in a speech to the 15-nation council by saying it was not a vote against peace between Israel and the Palestinians.
"The United States every day searches for new ways to take constructive steps to support the parties in making progress toward achieving a negotiated settlement," she said. "The Security Council resolution put before us today is not one of those constructive steps."
She said the text was "deeply imbalanced" and contained "unconstructive deadlines that take no account of Israel’s legitimate security concerns." To make matters worse, Power said, it "was put to a vote without a discussion or due consideration among council members."
She did not spare Israel either. "Today's vote should not be interpreted as a victory for an unsustainable status quo," Power said, adding that Washington would oppose actions by either side that undermined peace efforts, whether "in the form of settlement activity or imbalanced draft resolutions."
Jordanian Ambassador Dina Kawar, the sole Arab representative on the council, expressed regret that the resolution was voted down, while noting that she thought council members should have had more time to discuss the proposal.
The defeat of the resolution was not surprising. Washington, council diplomats said, had made clear it did not want such a resolution put to a vote before Israel's election in March.
The Palestinians, the diplomats said, insisted on putting the resolution to a vote despite the fact that it was clear Washington would not let it pass. Their sudden announcement last weekend that Ramallah wanted a vote before the new year surprised Western delegations on the council.
In order to pass, a resolution needs nine votes in favor and no vetoes from the council's five permanent members.
The European and African camps were split in the vote. France and Luxembourg voted in favor of the resolution while Britain and Lithuania abstained. Among the Africans, Chad voted yes while Rwanda and Nigeria abstained.
The Palestinians, frustrated by the lack of progress in peace talks, have sought to internationalize the issue by seeking UN membership and recognition of statehood via membership in international organizations.
Palestinian observer Riyad Mansour thanked delegations that voted for the resolution, noting that lawmakers in a number of European countries have called for recognition of Palestine. He said it was time to end the "abhorrent Israeli occupation and impunity that has brought our people so much suffering."
"It is thus most regrettable that the Security Council remains paralyzed," he said.
Mansour added that the Palestinian leadership "must now consider its next steps." The Palestinians have threatened to join the International Criminal Court, which they could then use as a forum to push for war crimes proceedings against Israel.
In a brief statement, Israeli delegate Israel Nitzan said the Palestinians have found every possible opportunity to avoid direct negotiations and brought the council "a preposterous unilateral proposal."
"I have news for the Palestinians - you cannot agitate and provoke your way to a state," he said.
French Ambassador Francois Delattre said Paris would continue its efforts to get a resolution through the council that would help move peace efforts forward.
"France regrets that it isn't possible to reach a consensus today," he said, noting that he voted for the resolution despite having reservations about its contents. "Our efforts must not stop here. It is our responsibility to try again."
An earlier Palestinian draft called for Jerusalem to be the shared capital of Israel and a Palestinian state. The draft that was voted on reverted to a harder line, saying only that East Jerusalem would be Palestine's capital and calling for an end to Israeli settlement building.
The Israeli government had said that a Security Council vote, following the collapse in April of US-brokered talks on Palestinian statehood, would only deepen the conflict.
Israel, which pulled troops and settlers out of the Gaza Strip in 2005, has said its eastern border would be indefensible if it withdrew completely from the West Bank.