The former U.S. Consulate on 18 Agron Road, now a branch of the U.S. embassy of Jerusalem that will service Palestinians through a special "Palestinian Affairs Unit".
A senior State Department official stressed the decision is an administrative one created to improve efficiency in operations.
The status of Jerusalem goes to the heart of the Israeli-Palestinian conflict.
Mr Pompeo said United States activities with Palestinians in the West Bank, Gaza and Jerusalem would now be run through a new "Palestinian affairs unit" inside the USA embassy that would operate from the current consulate site on Agron road.
In addition to relocating the embassy, the United States has slashed funding for the Palestinians by hundreds of millions of dollars - even for hospitals and for peace programs promoting Israeli-Palestinian coexistence - and closed the Palestine Liberation Organisation's office in Washington.
"The US decision. has nothing to do with "efficiency" and a lot to do with pleasing an ideological US team that is willing to disband the foundations of American foreign policy, and of the worldwide system, in order to reward Israeli violations and crimes", the Palestinians' chief negotiator Saeb Erekat said. He insisted the merger of the two missions did not signal a change in U.S. policy on the status of Jerusalem, the West Bank, or Gaza Strip.
But as the consulate is seen as the unofficial embassy to Palestinians, the move will be interpreted as another major blow from the Trump administrations against Palestinian aspirations for an end to occupation and their hopes of a state.
"Step by step, the Trump administration has worked to destroy the U.S. relationship with the Palestinians and to close off every point of contact with the Palestinian leadership", he said in a statement.
He said a new Palestinian Affairs Unit working as part of the embassy would continue to conduct "a full range of reporting, outreach and programming" with Palestinians.
Israeli sovereignty over Jerusalem has never been recognised internationally, and according to the 1993 Israel-Palestinian peace accords, the final status of Jerusalem is meant to be discussed in the latter stages of peace talks.
Eugene Kontorovich, a law professor with the Jerusalem-based Kohelet Policy Forum and advocate for the embassy move, said the decision was more evidence the United States considered Jerusalem to be fully part of Israel. SoS Pompeo's announcement closing the U.S. consulate in Jerusalem and transferring its responsibilities to the embassy ends the last vestige of American support for the city's division. "This decision has nothing to do with peace. Israel is deeply grateful", Oren tweeted.
During the past year, Washington has recognised the contested city of Jerusalem as Israel's capital and sought to dismantle vital USA engagement with the Palestinians, including slashing humanitarian aid to Palestinian refugees and shuttering their diplomatic offices in DC. The drafters of the plan, Trump's son-in-law Jared Kushner, his top Middle East negotiator Jason Greenblatt and his ambassador to Israel David Friedman, have taken pains to say that the plan will not necessarily endorse Palestinian statehood.