JERUSALEM - Israel announced on Wednesday it was limiting settlement construction for 10 months to try to revive peace negotiations with the Palestinians, but they said the step fell short of their terms for talks.

Prime Minister Benjamin Netanyahu called the move, which was immediately welcomed by ally the United States, a major step toward peace.

But his plan excluded areas of the West Bank that Israel annexed to its Jerusalem municipality after the 1967 war and building projects already under way -- falling short of the full freeze demanded by the Palestinians.

In an address to the nation, Netanyahu assured Israelis that building would begin again but he urged Palestinian leaders to respond to his gesture.

He then repeated nearly the entire prime time address in English, describing steps Israel says it has taken to improve living conditions for Palestinians in the West Bank, presumably speaking to an international audience.

Israel today has taken a far-reaching step toward peace, he said. It's time for the Palestinians to do the same.

However, Nabil Abu Rdainah, a spokesman for Palestinian President Mahmoud Abbas, said: Any return to negotiations must be on the basis of a complete settlement freeze, and in Jerusalem foremost.

The policy means there will be no new residential building permits issued for 10 months and that no new house building can start in that time in Judea and Samaria, Israel's terms for the West Bank excluding annexed areas around Jerusalem.

Israel's anti-settlement Peace Now group praised the decision as historic.

By imposing the construction limits, Netanyahu could hope to ease international pressure on Israel and win explicit U.S. backing, while putting the onus on the Palestinians to return to negotiations without preconditions as Washington has urged.

Within moments of his speech, U.S. Secretary of State Hillary Clinton and President Barack Obama's special Middle East envoy George Mitchell welcomed the Israeli move. They have been urging Abbas to renew talks without conditions.

Mitchell stressed that Washington still did not accept the legitimacy of settlements but said the Israeli move could have a substantial impact on efforts to resolve the conflict.

Clinton said the Israeli decision helps move forward efforts to resolve the decades-old conflict.

Defense Minister Ehud Barak said in a statement he hoped settler leaders would view the partial freeze in the context of ensuring good relations with the United States, citing the need to maintain Israel's military superiority in the region.

NATURAL GROWTH

Netanyahu has rejected a complete halt to construction in settlements, saying natural growth of settler families must be accommodated.

His governing coalition, which includes pro-settlement parties, did not appear to be in immediate danger of collapse after the security cabinet ratification.

Netanyahu has said the building of some 3,000 homes for Jews in the West Bank that were either under construction or about to be built would go ahead. Last week, Israel gave the green light for 900 new homes in a settlement near Jerusalem.

Some 500,000 Jews live in the West Bank and annexed areas around Jerusalem alongside 2.7 million Palestinians. The settlements, Palestinians fear, could deny them a viable state.

Obama had initially called on Israel to freeze settlement activity but later softened his position by appealing only for restraint, frustrating Palestinian leaders.

One minister in Netanyahu's cabinet, Dan Meridor, said it took the change in U.S. position for Israel to make the step.

There did not appear to be any direct link between Netanyahu's widely expected move on settlements and efforts that have gained speed over the past week to conclude a prisoner exchange deal between Israel and the Islamist Hamas group.

A source close to negotiations mediated by Egypt and Germany said Israel had rejected a demand for the release of two Hamas commanders as part of any swap for captured Israeli soldier Gilad Shalit, signaling talks had hit a snag.

One Palestinian official said no releases were now expected until after this weekend's Muslim holiday of Eid al-Adha.

Palestinian factions holding Shalit in the Gaza Strip since 2006 hope to trade him for hundreds of prisoners in Israeli jails. A deal would give a boost to Hamas, which seized the territory from Abbas's Fatah faction in 2007.

(Additional reporting by Sangwon Yoon in Jerusalem, Erika Solomon in Ramallah; editing by Angus MacSwan)

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