The confrontations in Umm el-Fahm, close to Israel's boundary with the occupied West Bank, underscored rising ethnic tensions throughout the Jewish state after years of bloodshed and diplomatic deadlock with the Palestinians.
Michael Ben-Ari, a politician from the far-right National Union party who took part in the march, described the event as an assertion of sovereignty in the face of Israeli Arabs who profess loyalty to the embattled Palestinians.
"I want to say that if we don't wave the flag in Umm el-Fahm ... we will bring a state of Palestine all the way to Tel Aviv," Ben-Ari said.
Umm el-Fahm is in an area of Israel, where many of the country's 1.5 million Arab citizens live, that ultranationalist Avigdor Lieberman wants to cede to a future Palestinian state in exchange for Jewish settlements in the occupied West Bank.
Lieberman is due to become foreign minister in the government that right-wing Likud leader Benjamin Netanyahu is forming.
More than 2,000 police were deployed as a buffer between the flag-waving Israelis, including many from openly anti-Arab political groups, and residents of Umm el-Fahm.
Toward the end of the march, scores of townspeople, some bearing Palestinian flags, threw rocks at the Jewish rightists and police, who responded with teargas and water cannon.
At least 16 residents and 15 police were injured. A police spokesman had no immediate word on any arrests. Among those rallying against the march were Jewish left-wing activists.
Arabs make up 20 per cent of Israel's population and, while enjoying full citizenship rights, complain of widespread racial discrimination. Some refuse to recognise Israel, which was founded in a 1948 war on what was then British-ruled Palestine.
"What is going on today is that we are being targeted by the Israeli entity," Islamist Arab leader Raed Salah told Reuters.
"It's trying to legitimise the transfer of the Palestinians who live inside Palestine," he said, referring to Israeli Arabs.
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