A far-right faction stormed out of the Israeli Government today in protest at plans by Ehud Olmert, the Prime Minister, to negotiate with the Palestinians on some of the most sensitive issues of the Middle East conflict.

Avigdor Lieberman, leader of the Yisrael Beitenu party, had told Mr Olmert on several occasions that he would resign if issues such as dividing Jerusalem were put on the table in talks with the Palestinian Authority. Mr Olmert authorised such discussions to go ahead this week after President Bush's visit to the region.

The walk-out reduced Mr Olmert's majority to 67 in the 120-seat parliament, cramping his room for manoeuvre but also freeing him of a persistent critic during the opening stages of his talks with the Palestinians.

“From our point of view, the concept of land for peace is out of the question,” said the Moldavan-born Mr Lieberman. “The principle must be exchanges of territory and population.”

Israeli right-wingers want to see a land swap that would incorporate Jewish settlements in the West Bank into Israel, and transfer areas of Israel dominated by Arabs into a future Palestinian state.

Mr Lieberman also levelled an attack against Israeli Arabs, who make up 20 per cent of the Jewish state's population, accusing them of harbouring plans to demand Palestinian citizenship after an independent Palestine is created.

“They don't hide this — they say quite clearly that they will demand autonomy in the Galilee and the Negev, and will never recognize Israel as a Jewish state,” he said.

Israeli Arab MPs expressed outrage at Mr Lieberman's comments, and called for his party to be outlawed. “Lieberman's remarks today are an incitement to murder. The man suffers from racial Aids and should be cured outside politics,” said Mohammad Barakeh a leading Arab member of the Knesset.

Mr Olmert also faced possible further walk-outs by the ultra-Othodox Shas party, which has voiced its disapproval about a possible division of Jerusalem.

Adding to his woes, Mr Olmert, 62, is facing the publication at the end of this month of a damning report into his leadership during the 2006 Lebanon war, which could put him under intense pressure to resign. He is also being investigated on several charges of corruption by the police and is suffering from prostate cancer, although the disease is said by doctors to be non-life threatening.

However, he has proven to be a slick political survivor since coming to power two years ago, giving Shas sought-after portfolios to ensure their loyalty. And many analysts predicted that Ehud Barak, the Defence Minister, who had threatened to lead his Labour party out of the coalition after the publication of the Winograd report on the Lebanese war, is unlikely to do so now, knowing that the right-wing Likud party would probably win any elections in the near future.

Mr Olmert may now make overtures to the left-wing Meretz party to shore up his administration. Yossi Beilin, a senior member of the party, said that Mr Lieberman's departure was a sign of hope. “Today, I think that Olmert is in a better position to proceed with the peace process.My hope is that now the way will be clear and there will be no excuses to proceed with an agreement in 2008.”

As a symbolic act, police today cleared Jewish settlers out of two small unauthorised outposts in the West Bank, a move demanded by Mr Bush during his visit. The young settlers, who believe the land belongs to Israel from the time of the Bible, vowed to return.

Further violence in Gaza marred hopes for any breakthrough in peace talks, with Israeli air strikes blowing up a car with three civilians in it, killing all the occupants -a boy of 12, his father and uncle.

An Israeli Army official said that the attack had been meant to target militants who have launched a massive barrage of rockets across the Gaza border into Israel. As many as 20 Palestinians, most of them Hamas gunmen, were killed the day before in heavy clashes in Gaza.

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