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Israeli Prime Minister Benjamin Netanyahu endorsed a Palestinian state beside Israel for the first time on Sunday, dramatically reversing himself in the face of US pressure but attaching conditions the Palestinians swiftly rejected.

"In my vision of peace there are two free peoples living side by side in this small land of ours as good neighbours and with mutual respect", said Netanyahu.

A week after President Barack Obama''s address to the Muslim world, Netanyahu said the Palestinian state would have to be unarmed and recognise Israel as the Jewish state.

Netanyahu, in an address seen as his response to Obama, refused to heed the US 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.

It was still a dramatic transformation for a man raised on a fiercely nationalistic ideology and who has spent a two-decade political career criticising peace efforts. "I call on you - our Palestinian neighbours and the leaders of the Palestinian Authority - let''s start negotiation for peace immediately, with no pre-conditions," he said, calling on the wider Arab world to work with him.

Since assuming office in March, Netanyahu has been caught between American demands to begin peace talks with the Palestinians and the constraints of a hardline coalition.

With his speech, he appeared to favour Israel''s all-important relationship with the US at the risk of destabilising his government.

Netanyahu laid out his vision in a half-hour speech broadcast nationwide during prime time. He spoke at Bar-Ilan University, known as a bastion of the Israeli right-wing establishment, and his call for establishing a Palestinian state was greeted with lukewarm applause.

As Netanyahu spoke, two small groups of protesters demonstrated at the entrance to the university. The Palestinians demand all of the West Bank as part of a future state, with east Jerusalem as their capital. Israel captured both areas in the 1967 Mideast war.

Netanyahu, leader of the hardline Likud Party, has always resisted withdrawing from those lands, for both security and ideological reasons.

In his speech, he repeatedly made references to Judaism''s connection to the biblical Land of Israel. But Netanyahu also said that Israel must recognise that millions of Palestinians live in the heart of the West Bank, and continued control over these people is undesirable.

Netanyahu has said he fears the West Bank could follow the path of the&' || 'nbsp;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. "If we get this guarantee for the demilitarisation and the necessary security arrangements for Israel, and if the Palestinians will recognise Israel as the state of the Jewish people, we will be ready in a real peace arrangement to come to a solution for a demilitarised 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."

Netanyahu also made no mention of uprooting Jewish settlements in the West Bank. Nearly 300-thousand Israelis live in the West Bank, in addition to 180-thousand Israelis living in Jewish neighbourhoods built in traditionally Arab east Jerusalem.

He also said that existing settlements should be allowed to grow - a position opposed by the US. Netanyahu also said the Palestinians must recognise Israel as a Jewish state.

The Palestinians have refused to do so, saying it would amount to giving up the rights of return for (m) millions of refugees and be discriminatory to Israel''s own Arab minority.