A petite blonde with tight blue jeans and honey-coloured skin sits atop a Styrofoam slab in a bright courtyard. The slab is made to look like a portion of the West Bank's separation wall. "On the one hand its grotesque," said 34-year-old Israeli artist Shelly Federman as she lit a cigarette on a balmy September night, "but I wanted to make the wall visible, and in doing so make people feel uncomfortable." About half a dozen of these sponge wedges — roughly a quarter of the size of their actual counterpart — encircle a small screen that has a short video on loop. During the clip you hear Mungo Jerry's melodic song Summertime blast from speakers, accompanying images of sun-drenched Israelis using the grey blocks as surfboards and lounge chairs on a pristine Tel Aviv beach.

Federman's installation is the centerpiece for Tel Aviv's inaugural biennial, ArtTLV, a city-wide art event featuring roughly 300 local and international artists. The three-week-long happening, taking place inside galleries, public courtyards and workshops, is the brainchild of a group of art collectors, gallerists and philanthropists – coincidentally, all of them Israeli women. Their aim was to create a "Mediterranean cultural triangle" between Tel Aviv, Athens and Istanbul in an effort to promulgate Israeli art and culture, and also to facilitate a vibrant exchange between the three cities.

After a small test run last year, the organisers of ArtTLV hired two well-established, foreign curators, Zdenka Badovinac and Viktor Misiano, to oversee the biennial's official inauguration this month, timed to take place during Tel Aviv's centennial celebrations and within days of the opening of the Istanbul Biennial. Yet, as the story so often goes in Israel, the grand triangular vision was torpedoed when Gaza was attacked in December 2008. After the onslaught began, Misiano and Badovinac announced they would only participate in the biennial if no government funding was accepted.

But then "the situation became a paradox", says Galia Yahav, Israel's most prominent art critic and former ArtTLV board member. The process of sourcing alternative funding began just months before the planned launch – and at the start of the global financial crisis. "Basically, no one knew how to raise the cash the curators expected in that short amount of time," said Yahav. Failure to secure the funding resulted in Badovinac and Misiano's departure, and a severance of cooperation between the biennial and the nearby Istanbul Biennial.

Thus ArtTLV shrunk and became, at least for its inauguration, a predominantly Israeli affair. The biennial's main exhibition space is centred on a seam of land that now divides the ancient city of Jaffa and Tel Aviv. It was here that the German Templars, a sect of the Lutheran Church that populated Palestine with agricultural communities, once lived. Their modest two-storey structures, built circa 1870, lay abandoned for decades, hidden behind sheaths of overgrown trees and rusted gates. Plans to build a 147-metre high, multi-million dollar tower next to the former Templar colony were sanctioned on the condition that developers renovated three of the dilapidated German structures. And so it was on 9 September 2009, inside these newly restored edifices in the shadow of a 44-storey concrete and glass skyscraper, that ArtTLV was born.

A little more subtle than Federman's squishy separation wall, is work from the artist Jan Tichy. His white paper tubes of uneven height, vertically affixed on top of a TV screen, stand out as one of the exhibition's most poignant critiques of Tel Aviv and its evolution. Streams of white lines radiating from the black monitor burn light on the paper cylinders, which effectively operate, in the artists words, "as a kind of organism that lurks below the city's surface". Tichy says the piece challenges the 2003 listing of Tel Aviv's collection of Bauhaus buildings – known as White City – as a World Heritage site: "Tel Aviv may be called the White City, but it sits on big, black issues. And in many ways it is the unseen here that has an immense influence."

On the biennial's opening day, the darkness Tichy described was nowhere to be seen; instead it was all cava and gourmet espresso. The city's art elite popped in and out of the templar buildings to see the hundreds of videos, paintings, photographs and multimedia pieces. On the streets, however, few had heard of the event, giving it an insular, navel-gazing quality. Still, much of the work on show had a delicious sense of humour and subtly acknowledged the awkwardness that comes with exhibiting in a country mired in political turmoil. Of particular interest was Su-Mei Tse's video of uniformed men and women sweeping desert sand, and Aharon Ozery's 6ft steel and aluminum contraption that moved large white eggs around several platforms.

Further afield, a small exhibit that marked the literary debut of Made Public: Palestinian Photographs in Military Archives in Israel, was one of the few pieces to focus on the Palestinian minority living in Israel. The book, written by Israeli curator Rona Sela, features images of Palestinian soldiers studying maps and preparing for battle before the establishment of the state in 1948. Sela recovered the images from the Israeli Ministry of Defence archives when they were opened to the public in 2002.

The absence of local Arab artists at ArtTLV is not entirely surprising. Staging a showcase funded by the Israeli government against the backdrop of the city's centennial celebrations meant Palestinian artists living in Israel sidestepped participation. Despite the potential for controversy, Said Abu Shakra, director of the country's only Arab arts museum in Umm el-Fahm, curated an exhibit entitled A Place of Memory, which featured photographs of prominent Palestinians who reside in the northern Wadi Ara region. But international Arab representation was limited to artists Mounir Fatmi, who displayed a collection of 1,500 VHS cassettes arranged like a cluster of high-rises for his piece Skyline, and Kader Attia, whose work Fragility showed a series of sculpted plastic bags perched atop pillars.

When the opening gala was in full swing, Federman's separation wall slabs were subject to a barrage of accidental kicks and falls by passersby. These unintentional assaults were precisely what Federman sought when she conceived of the project. "I am trying to show the audience that there is no way to be passive, because when you are passive you are actually taking part in something that is terrible. By bringing the wall here, I want to bring the responsibility back."

A young woman in stiletto heels came over to greet Federman. As she stepped on to a wedge to take a seat, she punctured the surface with four golf ball-size holes. Federman smiled as she surveyed the damage. "Looks like rocks were thrown on it," she said, exhaling a plume of smoke. "Makes it look real."