A key ally of Prime Minister Ehud Olmert said Sunday that Israel will hold on to all Jewish neighborhoods of Jerusalem but would have to relinquish Arab neighborhoods in a peace agreement with the Palestinians.

The comments by Vice Premier Haim Ramon appeared aimed at defusing U.S. criticism of an Israeli plan to expand one of its Jewish neighborhoods in east Jerusalem, the section Palestinians claim as capital of a future state.

Israeli-Palestinian peace negotiations are set to resume Wednesday under an agreement reached at last month's Mideast peace conference in Annapolis, Md. A senior Palestinian official charged Sunday that Israel is already negotiating in bad faith about Jerusalem, one of the touchiest issues on the table.

"These statements place obstacles before any serious attempts by Palestinian negotiators on Jerusalem," Palestinian Foreign Minister Riad Malki said. "They aim to create confusion and change the course of negotiations before they begin. They try to pressure Palestinians and the international parties to think of Israeli needs before they begin."

Despite official opposition, some Palestinians have indicated they would consider a division along the lines Ramon described. In 2003, some leading moderates signed on to an unofficial plan that includes such a concept.

Altogether, about 500,000 Jews and 230,000 Arabs live inside Jerusalem's expanded boundaries, set by Israel in 1967 after it captured the eastern part of the city.

Ramon, who often speaks for Olmert, said Har Homa, the newest Jewish neighborhood, would remain Israeli, along with the older ones where about 180,000 Israelis live. Last week, Israel published ads seeking bids from developers to build 307 additional housing units in Har Homa, triggering protests from the Palestinians and U.S. Secretary of State Condoleezza Rice, who said the new apartments would not "help to build confidence" for new peace talks.

"The Jewish neighborhoods, including Har Homa, will remain under Israeli sovereignty, and the Arab neighborhoods will be the Palestinian capital, which they will call Jerusalem or whatever they want," Ramon said in an interview on Israel Radio. "Then we won't get embroiled, as is happening now, in an uncalled-for and badly timed debate with the United States, at a time when we need its support."

Ramon explained that if Israel does not relinquish control of heavily populated Palestinian areas, its character as a Jewish state will be undermined.

Ramon's formula _ retaining Jerusalem's Jewish neighborhoods and giving Arab sections to the Palestinian state _ is similar to one presented by then-President Bill Clinton and discussed at the last round of peace talks in January 2001. Ramon first referred to the concept several months ago.

Those talks ended inconclusively as Israeli forces fought Palestinian militants at the beginning of the second Palestinian uprising, marked by bloody Palestinian suicide bombings in Israeli cities and punishing Israeli raids in the West Bank and Gaza.

On Sunday, Arab League chief Amr Moussa said the new construction plan was a "flagrant violation of the Annapolis summit and international law that considers the West Bank, including east Jerusalem, as occupied land."

Israel captured east Jerusalem, including the Old City with its holy sites, in the 1967 Mideast war along with the West Bank and Gaza Strip. Unlike the other territories, Israel annexed east Jerusalem, with its Arab population, and has built a string of Jewish neighborhoods around the city.

Though no other country recognized the annexation, Israel considers the entire city to be its capital, while Palestinians insist east Jerusalem is part of the West Bank.

Palestinians want to set up their state in the West Bank, Gaza and east Jerusalem. They consider the Jewish sections of east Jerusalem to be illegal settlements like those in the West Bank and insist that they all be removed. That is widely seen as an opening negotiating position.

Even if a division of the neighborhoods were agreed on, a serious sticking point would remain _ the walled Old City and its hotly disputed holy site, where the Al Aqsa Mosque compound sits atop the ruins of the biblical Jewish temples. Both Israel and the Palestinians demand sovereignty over the site.

The competing claims to Jerusalem have derailed past peace talks and are already complicating the new round before it starts. The sides have pledged to try to work out a final peace deal by the end of 2008.

Also Sunday, one of Israel's leading human rights groups harshly criticized the government for widespread violations in the West Bank and Gaza, harming Palestinians economically and socially.

The annual report of the Association for Civil Rights in Israel (ACRI) also faulted the nation for increasing racism in its treatment of minorities, especially Arabs.