Outposts are small unsanctioned communities which have sprung up in the West Bank in the last 20 years. Many are very close to existing settlements. The outposts are currently considered illegal under Israeli law, as well as international law.
Fifty-seven lawmakers voted to approve the draft legislation, while 51 were against it.
It needs to be passed two more times by parliament before it becomes law.
The bill would allow settlers living in these outposts to remain in homes built on private Palestinian land. The original landowners would receive compensation.
Proponents of the bill drawn from the right-wing Jewish Home party, a coalition partner of Prime Minister Benjamin Netanyahu, see it as paving the way for the annexation of the West Bank.
Speaking on Israeli radio, Jewish Home leader Naftali Bennett described the prospect of the bill becoming law as an "historic event."
One outpost the new legislation would not cover is Amona, which lies about 20 kilometers north of Jerusalem. A provision in the bill that would save it has been dropped.
Amona is currently slated for demolition by December 25 after the Supreme Court ruled it had to come down. Palestinian leaders condemned Monday's vote.
PLO Executive Committee member Hanan Ashrawi called it a "legal travesty."
In a statement she said: "Israel is persistently and willfully legislating outside the realm of international law in order to legalize its criminal settlement agenda, considered a war crime under the Rome Statute of the International Criminal Court."
The United Nations Special Coordinator for the Middle East peace process Nickolay Mladenov urged Israeli lawmakers to vote against the bill at subsequent readings.
In a statement, he said: "If adopted, it will have far reaching legal consequences for Israel, across the occupied West Bank, and will greatly diminish the prospect of Arab-Israeli peace."
Earlier this month, Palestinian officials were known to be working on a draft UN Security Council resolution critical of Israel's settlement policy, though it was never presented to the council for discussion.
Over the weekend, US Secretary of State John Kerry was highly critical of Israel's settlement policy. He told a conference in Washington that "things were moving in the wrong direction" and said that he did not believe Israel supported a two-state solution.