Culture Minister Miri Regev announced she was seeking an investigation into the al-Midan theatre in the mixed Palestinian-Israeli city of Haifa following the refusal.
"The theatre is not a political body," Regev told Israeli media. "Theatre cannot be a front for incitement against Israeli soldiers."
She had asked the attorney general to open an investigation, she added in a post on Facebook.
In 2015, the Israeli government announced it would withdraw state funding for the theatre after it hosted the play "A Parallel Time".
The play was apparently inspired by the story of Walid Daka, a Palestinian imprisoned for his role in abducting and killing Israeli soldier Moshe Tamam in 1984.
The ministry justified the freeze by arguing that the play was written by a "terrorist" who kidnapped and killed a soldier, eliciting criticism that it was impinging on freedom of expression.
The controversy was resolved in 2016, but in a recent interview the theatre's director Amer Hlehel refused to call Daka a terrorist, instead labelling him a "security prisoner".
The workers of al-Midan are now going on strike, claiming that Regev has simply ceased transferring funds since March 2016.
Joseph Atrash, chairman of the theater's board, responded to Regev's comments in statements to Channel 10.
"After Minister Regev claimed for the past four months that the freeze of funding for the al-Midan Theater was an administrative matter only and was not about political persecution, today Minister Regev exposed the real face of Israeli democracy," he said.
"We have news for you, Minister Regev; the al-Midan Theater will not close."
Agencies contributed to this report.
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