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Palestinians have said they would not revive stalled peace talks with Israel unless its settlement activities stopped, that they have recognized Israel under past interim peace deals and that refugees must be compensated or resettled. "If settlement continues Israel will be allowed to build one thousand units here and two thousand units there, which will lead Arabs and Palestinians to believe that the American administration is incapable of swaying Israel to halt its settlement activities," Erekat told the radio. "The message is clear: settlements should stop immediately."

"There are no middle-ground solutions for the settlement issue: either settlement activity stops or it doesn't stop," Saeb Erekat told Voice of Palestine radio. Erekat said Palestinian President Mahmoud Abbas expressed that message in a letter Saturday to U.S. President Barack Obama.

Erekat was responding to reports Israel and the United States were discussing a compromise that would allow some building in existing settlements under what Israel terms "natural growth" to accommodate expanding families.

A U.S. official denied Wednesday a report in the Israeli daily Maariv that the Obama administration agreed work could continue on 2,500 housing units whose construction had begun, despite its call for a total freeze to spur peace efforts.

Netanyahu, in an address seen as his response to Obama, refused to heed the U.S. call for an immediate freeze of construction on lands Palestinians claim for their future state. He also said the holy city of Jerusalem must remain under Israeli sovereignty.

''I call on you, our Palestinian neighbors, and to the leadership of the Palestinian Authority: Let us begin peace negotiations immediately, without preconditions,'' he said, calling on the wider Arab world to work with him. ''Let's make peace. I am willing to meet with you any time any place -- in Damascus, Riyadh, Beirut and in Jerusalem.''

''Our right to form our sovereign state here in the land of Israel stems from one simple fact. The Land of Israel is the birthplace of the Jewish people,'' he said.

''In my vision, there are two free peoples living side by side each with each other, each with its own flag and national anthem,'' he said.Netanyahu has said he fears the West Bank could follow the path of the Gaza Strip -- which the Palestinians also claim for their future state. Israel withdrew from Gaza in 2005, and Hamas militants now control the area, often firing rockets into southern Israel.''In any peace agreement, the territory under Palestinian control must be disarmed, with solid security guarantees for Israel,'' he said.

'If we get this guarantee for demilitarization and necessary security arrangements for Israel, and if the Palestinians recognize Israel as the state of the Jewish people, we will be willing in a real peace agreement to reach a solution of a demilitarized Palestinian state alongside the Jewish state,'' he said.

Netanyahu gave no indication as to how much captured land he would be willing to relinquish. However, he ruled out a division of Jerusalem, saying, ''Israel's capital will remain united.''

''We have no intention to build new settlements or expropriate land for expanding existing settlements. But there is a need to allow residents to lead a normal life. Settlers are not the enemy of the nation and are not the enemy of peace -- they are our brothers and sisters,'' he said.

Netanyahu also said the Palestinians must recognize Israel as a Jewish state. The Palestinians have refused to do so, fearing it would amount to giving up the rights of millions of refugees and their descendants and discriminate against Israel's own Arab minority.Although the Palestinians have agreed to demilitarization under past peace proposals, Erekat rejected it, saying it would cement Israeli rule over them.

An aide to Palestinian President Mahmoud Abbas, meanwhile, said Sundaythat the speech "sabotages" regional peace efforts, due to Netanyahu's refusal to accept an influx of Palestinian refugees into Israel and his unwillingness to compromise on the status of Jerusalem.

"Netanyahu's remarks have sabotaged all initiatives, paralyzed all efforts being made and challenges the Palestinian, Arab and American positions," said Nabil Abu Rudeinah.

Netanyahu pledged in the address that Jerusalem be the undivided capital of Israel and that Palestinian refugees not be allowed into Israel

A senior Palestinian negotiator, meanwhile, called on U.S. President Barack Obama to intervene to force Israel to abide by previous interim agreements that include freezing settlement activity in the West Bank. The alternative, he said, was violence. "President Obama, the ball is in your court tonight," Saeb Erekat said. "You have the choice tonight. You can treat Netanyahu as a prime minister above the law and ... close off the path of peace tonight and set the whole region on the path of violence, chaos, extremism and bloodletting.

"The alternative is to make Netanyahu abide by the road map," he said, referring to a U.S.-sponsored document under which Israel agreed to freeze settlement activity and Palestinians agreed to rein in militants hostile to Israel. "The peace process has been moving at the speed of a tortoise," Erekat added. "Tonight, Netanyahu has flipped it over on its back."

But the White House called the policy outline an "important step forward", as did French Foreign Minister Bernard Kouchner.

Mr Erekat added: "The peace process has been moving at the speed of a tortoise. Tonight, Netanyahu has flipped it over on its back."

In Gaza, Hamas spokesman Sami Abu Zuhri described the speech as "racist" and called on Arab nations to "form stronger opposition" towards Israel.

A White House statement said Mr Obama "believes this solution can and must ensure both Israel's security and the fulfilment of the Palestinians' legitimate aspirations for a viable state, and he welcomes Prime Minister Netanyahu's endorsement of that goal".

In his own keynote Middle East speech in Cairo on 4 June, Mr Obama stressed that he wanted all settlement activity to stop. But Mr Netanyahu said settlers were not "enemies of peace" and did not move from his position of backing "natural growth" in existing settlements.

The settlers group Yesha condemned Mr Netanyahu's speech: "We deplore that the prime minister has agreed to the creation of a demilitarised Palestinian state after he has said for years that such a state, even demilitarised, would be a threat to Israel."

Newsweek notes the offer was made in September 2008, when Olmert was heading a transition government and had already resigned from his post, rendering coalition considerations irrelevant.

Olmert also told Newsweek he suggested to Abbas Israel would withdraw from 93.5 to 93.7 per cent of the West Bank, compensating the Palestinians with territory equivalent to 5.8 per cent of the West Bank, and allow for direct crossing between the West Bank and the Gaza Strip.

He stressed he rejected Palestinian demands to realize the right of return, and instead offered a "humanitarian gesture" of accepting a small number of Palestinian refugees, "smaller than the Palestinians wanted, a very, very limited number."

Olmert's offer was confirmed to Newsweek by Saeb Erekat, the chief Palestinian negotiator. "It's very sad. He was serious, I have to say," Erekat said. He said that he and Abbas began preparing a response, but within a few months the Gaza war erupted, and Olmert had left office.

Nabil Abu Rdainah, a spokesman for Mahmoud Abbas, the Palestinian president, dismissed the speech, saying: "Netanyahu's remarks have sabotaged all initiatives, paralysed all efforts being made and challenges the Palestinian, Arab and American positions."

Saeb Erekat, the Palestinians' senior negotiator, called on Obama to intervene to force Israel to abide by previous interim agreements that include freezing settlement activity in the West Bank. "The peace process has been moving at the speed of a tortoise. Tonight, Netanyahu has flipped it over on its backm," he said.

This is the first occasion that Netanyahu has endorsed the creation of a Palestinian state, but many see a disarmed Palestinian state as handing too much power to Israel. "Netanyahu did not accept the principle of a two-state solution," Lamis Andoni, Al Jazeera's Middle East analyst, said. "He reduced the concept of a Palestinian state to that of a demilitarised entity that would remain under Israeli control. 

"This is at best a formula to establish a Palestinian Bantustan that will not end the Israeli occupation but would legitimise Israeli control."

The Palestinians have said that they will not restart negotiations unless Netanyahu publicly backs the two-state solution and stops the building of Jewish settlements on Palestinian land.

He said there would be an end to new settlement building, but vowed that Jerusalem would remain undivided. Addressing Palestinian, Netanyahu urged them to recognise Israel as a Jewish state. "Israel is the nation state of the Jewish people and so it shall remain," he said.