Israeli Prime Minister Ehud Olmert balked on Thursday at committing to a total freeze in settlement activity, a key demand of Palestinian President Mahmoud Abbas for advancing U.S.-backed peace talks.

But the leaders agreed during their two-hour meeting to press ahead with negotiations that have been paralyzed since Israel announced plans to build hundreds of new homes in an area near Jerusalem known to Israelis as Har Homa and to Palestinians as Jabal Abu Ghneim.

"We won't agree with the Palestinians on every issue on day one," Olmert's spokesman, Mark Regev, said after the meeting at Olmert's Jerusalem residence. "The Palestinians have their positions. We have ours. And the commitment is to work to overcome gaps."

The meeting between Olmert and Abbas was their first since a U.S. peace conference last month in Annapolis, Maryland, in which the leaders launched final-status negotiations with the goal of reaching a statehood agreement before U.S. President George W. Bush leaves office in January 2009.

Palestinian negotiator Saeb Erekat said Abbas sought a halt to all settlement activity, including so-called natural growth, as spelled out in the long-stalled "road map" peace plan.

While Olmert agreed not to take any steps that might prejudice the outcome of the negotiations, he reiterated Israel's position on building within Har Homa, Regev said.

A senior Israeli official added: "The prime minister has not promised to freeze (housing) tenders that have already been published and are already under way."

Bush will visit the region early next month but it is unclear how Olmert and Abbas, weakened politically at home, can bridge their differences.

Ahead of Bush's arrival, Israel is considering easing criteria for freeing Palestinian prisoners, a move one Israeli official said could pave the way for the release of uprising leader Marwan Barghouthi, seen as a possible successor to Abbas.

Easing Israeli restrictions on releasing prisoners with so-called "blood on their hands," a reference to attacks against Israelis, was part of efforts to secure a swap deal with Hamas for captured Israeli soldier Gilad Shalit.

INTERPRETING THE ROAD MAP

The Palestinians argue that the road map's explicit call for a halt to all settlement activity means all Israeli building on occupied land, including within Har Homa, is prohibited.

Israel has a different interpretation of the road map, arguing that construction within built-up areas of existing settlements is permissible as long as no new settlements are built and no additional occupied lands are confiscated.

Olmert told Abbas the Palestinians must meet their own road map commitments to rein in militants in the West Bank and the Hamas-controlled Gaza Strip, a condition set by Israel for establishing a Palestinian state, officials said.

Hamas seized Gaza in June after routing Abbas's secular Fatah forces, and militants use the coastal territory to fire rockets into Israel. Israel killed at least four Gaza militants on Thursday during and after the Olmert-Abbas meeting.

Hamas official Sami Abu Zuhri said Olmert's refusal to halt all settlement activity proved "the pointlessness of the negotiations."

Palestinians see the building of Har Homa as the last rampart in a wall of settlements encircling Arab East Jerusalem, cutting it off from Bethlehem and the rest of the occupied West Bank. They say it is a strategic move by Israel to pre-empt any possibility of East Jerusalem becoming the Palestinian capital.

Israel's Har Homa plan has also drawn rare criticism from the United States, Israel's key ally. Construction at the same settlement derailed a previous round of talks in 1997.

In addition to Har Homa, Israel has announced plans for new building within the Maale Adumim settlement which the Jewish state hopes to keep as part of any final peace deal.