The Israeli Prime Minister, Ehud Olmert, declared last night that Israel reserved the right to expand existing Jewish settlements in Arab East Jerusalem and in parts of the West Bank that it hopes to retain in any final peace deal.

In terms which appeared to defy earlier sharp criticism by the US Secretary of State, Condoleezza Rice, Mr Olmert made it clear in front of President George Bush that he regarded such expansion as outside the "moratorium" he has promised on new settlement building. His declaration came as the US President, on his first visit in office to Israel, used some of his strongest language yet in demanding the dismantling of separate settlement outposts which are illegal even under Israeli law. Mr Bush said at a joint news conference last night: "We have been talking about it for four years – illegal outposts. They ought to go."

Mr Olmert did not demur from that and repeatedly emphasised that Israel was very serious about advancing a negotiating process over the coming year. Mr Bush said the resumption of formal negotiations between Mr Olmert and the Palestinian President, Mahmoud Abbas, presented a historic moment, a historic opportunity.

But the Israeli Prime Minister argued that his commitment not to build new settlements or acquire further Palestinian land neither applied to Jerusalem nor to the large Jewish settlement blocs which Mr Bush indicated in 2004 they could retain in any final status deal, further endearing himself to Israeli leaders.

Mr Olmert said: "Jerusalem is not the same status. The [Jewish] population centres are not the same status. He pointed out that President Bush had not demanded any commitments beyond those he had already made.

Earlier Ms Rice had reinforced the complaints of Palestinian negotiators that a decision to build 300 extra homes in the East Jerusalem settlement of Har Homa had badly soured the opening of talks after the Annapolis summit.

Ms Rice, who is sometimes depicted in Israel as having amore visceral sympathy for Palestinian aspirations than Mr Bush, said that Har Homa had been a settlement the US opposed from the beginning.

Mr Olmert said Palestinian negotiators – who have been seeking the full-scale freeze on all settlement activity envisaged in the road map – might not be in love with this but that it would be discussed with them.

The Israeli Prime minister also warned that rocket attacks from Gaza – some of which yesterday struck the southern Israeli border town of Sderot – would have to be halted before any peace deal could be implemented. Three Palestinians were killed as Israel launched a counter-attack on the rocket launchers following the barrage, which scored two direct hits on houses in Sderot. Two of the dead Palestinians were civilians, according to Palestinian sources.

Promising that Israel would take whatever steps were necessary to stop these attacks, Mr Olmert appeared to rule out any idea of a West Bank-only peace deal with Mr Abbas's Ramallah-based emergency government – which does not include Hamas, currently in de facto control of Gaza. "There will be no peace until terror is stopped. Terror will have to be stopped everywhere," he said.

Repeatedly endorsing the sincerity of both Mr Olmert and Mr Abbas's desire to reach an agreement, President Bush said the conclusion of a vision of what a future Palestinian state would look like, would allow Mr Abbas to give the Palestinian people a choice between the dark goals of Hamas and the hope afforded by a Palestinian state.

Shimon Peres, the Israeli President, had earlier made a point of tactfully underlining Israeli disquiet at some reactions to the US National Intelligence Assessment suggesting that Iran had shelved active pursuit of a secret nuclear weapons programme four years ago. Mr Peres told Mr Bush: We take your advice to not underestimate the Iranian threat. Iran should not underestimate our resolve for self-defence.

While saying that he believed that diplomatic means – including tightening economic sanctions – would bring a solution, Mr Bush reassured Mr Olmert last night that the US regarded Iran as a threat, and that it would continue to be a threat if the international community did not come together to prevent it from developing the know-how to build a nuclear weapon.

On the naval confrontation apparently videoed in the Straits of Hormuz, he said that Iran had made a provocative, dangerous gesture and there would be serious consequences if they attacked US ships.

The earlier ceremonials between the Israeli establishment and the man considered Israel's greatest friend had the flavour of a love-in on a grand scale which transcended mere diplomacy. President Peres told Mr Bush: " You came to a land and a people that loves deeply the United States of America without any reservations."

The warmth of the official Israeli welcome after Mr Bush stepped off Airforce One at Ben Gurion airport to stand, hand on heart, as an Israeli military band played the "Star-Spangled Banner", and then the Israeli national anthem, "Hatikva", was unaffected by the wholesale disruption to everyday life in Jerusalem triggered by his visit.