Binyamin Netanyahu threw down the gauntlet to the US last night, grudgingly agreeing to a limited Palestinian state that would be demilitarised and not in control of its airspace or borders.

The hawkish Prime Minister insisted that Israel would never give up a united Jerusalem as its capital, and said that established Jewish settlements in the West Bank would continue to expand — despite explicit objections from Washington.

In a keynote speech that referred to a Palestinian “entity” far more frequently than an actual state, Mr Netanyahu tried to advance elements of his economic peace plan — whereby the Palestinians would get increased investment but only limited sovereignty — while still conceding to US insistence on the creation of an independent Palestinian country.

The right-wing Israeli leader said the moderate Palestinian leadership in the West Bank must agree to recognise Israel as the homeland of the Jewish people, as well as fight the Islamic hardliners Hamas, who now control Gaza, in return for the resumption of peace talks.

“The key condition is that the Palestinians recognise in a clear and public manner that Israel is the state of the Jewish people,” he told dignitaries in an auditorium at Bar Ilan University in Tel Aviv. “If we have the guarantees on demilitarisation, and if the Palestinians recognise Israel as a state of the Jewish people, then we arrive at a solution based on a demilitarised Palestinian state alongside Israel,” Mr Netanyahu said.

“Each will have its flag, each will have its anthem. The Palestinian territory will be without arms, will not control airspace, will not be able to have arms enter.”

He said that “effective security safeguards” would have to be in place, without specifying what they might be. Israeli military officers have long argued that without an Israeli military presence, the Fatah-controlled West Bank would quickly fall to the Iranian-backed Hamas, which took control of Gaza two years ago amid fierce fighting.

Mr Netanyahu said that Hamas rocket-fire from Gaza, attacking Israeli cities in the south, would quickly reach Tel Aviv and its airport if the Islamist hardliners came to control the West Bank. “Many a worthy person has told us that withdrawal is the key to peace between us and the Palestinians. But the fact is that every withdrawal has been accompanied by rockets and suicide attacks.” He said that the Palestinians had to drop the right of return for hundreds of thousands of refugees to their homes inside Israel.

Mr Netanyahu has been forced to tread a fine line between placating his largely nationalist-religious coalition while not flying in the face of Israel’s main ally, the US — which wants a total halt to all settlement growth and recognition of an independent Palestinian state. He said last night that he would not agree to US demands for a total freeze on the expansion of Jewish settlements in the West Bank.

“I do not wish to build new settlements or to confiscate lands to that end, but we have to allow the residents of the settlements to live normal lives,” he said.

The much anticipated speech, in part a response to President Obama’s address to the Muslim world in Cairo two weeks ago, was condemned by the Palestinian Authority in the West Bank. “This speech torpedoes all peace initiatives in the region,” said Nabil Abu Rudeina, a spokesman for Mahmoud Abbas, the Palestinian President. Yasser Abed Rabbo, a senior Palestinian official, said that Mr Netanyahu “spoke of a Palestinian state while emptying it of any substance by excluding a stop to settlements”.

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