JERUSALEM - Israel's deputy prime minister responded on Sunday to U.S. criticism of plans to build homes on occupied land in the Jerusalem area by saying parts of the city must be given to the Palestinians to avoid losing U.S. support.

But Haim Ramon told Israeli radio that Israel would not give up the Jewish settlement where the building plan announced last week sparked Palestinian anger and a warning from U.S. Secretary of State Condoleezza Rice that it risked harming a peace process she helped relaunch last month at the Annapolis conference.

Israel has rejected criticism of a tender for some 300 more homes and other units at Har Homa -- which Arabs call Abu Ghneim -- on the grounds that it annexed the land and placed it inside Jerusalem city boundaries it drew after occupying the West Bank in 1967. That annexation is not recognised internationally.

Ramon said, however, that Prime Minister Ehud Olmert's opponents were being unrealistic in hoping for U.S. support for any peace plan that would give the Jewish state all the present Jerusalem municipality, which includes Arab East Jerusalem and other territory annexed from the West Bank, as its capital.

Palestinian President Mahmoud Abbas wants East Jerusalem as capital of a Palestinian state in the West Bank and Gaza Strip.

Ramon told Army Radio: "I am convinced that all Jewish neighbourhoods, including Har Homa, should be under Israeli sovereignty and the Arab neighbourhoods should not be under Israeli sovereignty because they pose a threat to Jerusalem being the capital of Jewish Israel."

Palestinian leaders have said the new building project could wreck U.S.-backed peace talks and, in rare U.S. public censure of Israel, Rice on Friday warned it could threaten the peace drive, saying the plan "doesn't help to build confidence".

Ramon said giving up Palestinian villages incorporated into Jerusalem after 1967, such as Walajeh and Jabal Mukaber, could avoid further rebuke from the United States at a time Israel needs its backing.

INSIDE JERUSALEM

Israel has rebuffed Rice's criticism, saying the Jewish state has the right to build anywhere in Jerusalem.

Israeli Construction and Housing Minister Zeev Boim said before a cabinet meeting on Sunday the plan was legal because it took place "within the framework of the municipality". Education Minister Yuli Tamir also said that while Israel must be "very careful" not to violate international agreements, Har Homa fell within city boundaries.

The future of Jewish settlements under any peace deal is one of the thorniest issues facing negotiators, who are due to meet on Wednesday for their first talks since launching the long-stalled peace process in Washington almost two weeks ago.

U.S. President George W. Bush wants an agreement on Palestinian statehood before he leaves office at the end of next year but many observers say that time scale is too ambitious given big differences on core issues such as Jerusalem, borders -- including settlements -- and Palestinian refugees.

Under a U.S.-backed "road map", Israel must freeze settlement activity and Palestinians are required to rein in militants.

Hundreds of Jewish outposts have sprouted without government authorisation. Right-wing activists who oppose ceding land to the Palestinians climbed craggy West Bank hills to protest on Sunday and said they planned to erect more outposts.

Israel wants to draw a fortified border through the West Bank that would place major Jewish settlements inside a newly defined Israel and says it could remove outlying communities.