Washington welcomed Prime Minister Benjamin Netanyahu's offer, but the Palestinians swiftly rejected it because it did not include a building freeze in Jewish neighborhoods in East Jerusalem, the mainly Arab sector of the city they want as the capital of a future state.

Secretary of State Hillary Rodham Clinton said the Israeli decision was a helpful move toward resolving the Israeli-Palestinian conflict.

The administration's special envoy for Mideast peace, former Sen. George Mitchell, also welcomed the move but said it fell short of a full settlement freeze.

"But it is more than any Israeli government has done before and can help movement toward agreement between the parties," he said, adding that he planned to return to the Mideast "in the near future" to resume his efforts to win agreement from the Israelis and Palestinians to return to the negotiating table.

Palestinian Authority President Mahmoud Abbas has demanded a total halt to settlement construction before peace talks can resume, but the Obama team has struggled in dealing with that demand.

On the one hand, the United States rejects the legitimacy of Israeli settlements and has harshly criticized Israel's construction in East Jerusalem, but on the other, it wants the two sides to sit down and work out their differences.

Netanyahu said the "far-reaching and painful step" was designed to "encourage resumption of peace talks with our Palestinian neighbors." He added: "Israel's government has made an important step toward peace today. Let us make peace together."

The freeze applies only to new housing, meaning about 3,000 units under construction can be finished.

"We will not halt existing construction, and we will continue to build synagogues, schools, kindergartens, and public buildings essential for normal life" in the settlements, Netanyahu said in a statement broadcast live from his office. About 300,000 Israelis live in West Bank settlements.

'He had a choice'

"This is not a moratorium," he said. "Unfortunately, we hoped he would commit to a real settlement freeze so we can resume negotiations, and he had a choice between settlements and peace, and he chose settlements."

Speaking a day before Israel officially made its proposal, Abbas adviser Nabil Abu Rdeneh said the freeze would be unacceptable if it did not include East Jerusalem. "Any Israeli offer that doesn't include Jerusalem will be rejected immediately," he said. "No Palestinian, no Arab can cross this line."

Israel captured East Jerusalem from Jordan in the 1967 Mideast war and annexed it, a step no nation has recognized. Trying to cement its claim, Israel built new quarters around East Jerusalem, where 180,000 Israelis now live. Palestinians denounce them as settlements, but Israel considers them neighborhoods.

Israel committed to a total freeze in settlement construction in the West Bank in 2002, when it accepted the U.S.-backed "road map" peace plan, which is still considered a viable blueprint.

Prisoner exchange

Netanyahu and his backers support settlement construction in principle. He has said that peace talks must resume without preconditions, and issues like settlements should be discussed in negotiations.

The settlement construction issue briefly overshadowed tense, indirect negotiations between Israel and the extremist Islamic Hamas rulers of Gaza over a deal under which a captured Israeli soldier will be exchanged for hundreds of Palestinian prisoners. After optimistic signs earlier in the week, it appeared yesterday that a deal was at least a week away.

Hamas officials said yesterday that the talks had hit a snag over some of the extremists the Islamic group wants freed and that a deal was unlikely in the coming days.

Khalil al-Haya, a Hamas leader in the Gaza Strip, blamed Israel for the delay. He told a local news Web site that Israel "has not yet responded to the demands of the factions holding Gilad Shalit," the soldier captured in a 2006 border raid by Palestinian extremists, who killed two other soldiers.

Israel is objecting to some of the names put forward by Hamas, a top Hamas official said.