The disputed fate of Jerusalem has long epitomized the stalemate in the Middle East peace process, and over the past two weeks it has been at the center of rare diplomatic brawl between Israel and the U.S. But even as the Obama Administration and the Israeli government square off over demands that Israel refrain from announcing new construction projects in occupied East Jerusalem, the tussle as Israel extends its grip and Palestinians push back is a flashpoint. "The tinder is dry in Jerusalem," says one Western diplomat. "Israeli moves on the ground have been a source of tension, and Palestinian side is heating up the atmosphere as well. It's unwise to predict an explosion, by the slightest spark could cause one."

Jerusalem is just one of a number of difficult "final status" issues to be negotiated in pursuit of a two-state solution — others include where to draw the borders; the fate of settlers and of Palestinian refugees who fled their homes in Israel in 1948 and were barred from returning; security; and water rights. But the fate of the Holy City is easily the most emotive, and perhaps also the most intractable point of conflict. And the very process of trying to restart final-status talks has once again put Jerusalem at ground zero in the conflict. (See pictures of people protesting the new settlements in East Jerusalem)

The standoff between Prime Minister Benjamin Netanyahu and the Obama Administration concerns whether Israel can build in those parts of the city it captured in the war of 1967 — the Jewish state's claims to East Jerusalem are not internationally recognized, and building there is considered settlement activity by the U.S. and the rest of the international community. In order to restart peace talks, the Obama Administration has demanded that Israel freeze all settlement construction, in line with its obligation to do so under President Bush's 2002 peace road map. Netanyahu demurred, offering instead a temporary slowdown in West Bank settlement construction, but refusing to apply it in Jerusalem. The Palestinians claim East Jerusalem as the capital of a future state, and see Israeli settlement there — and in the West Bank — as reasons to doubt Israel's intent to conclude a peace agreement.

Even Israelis working for a two-state solution warn that time is running out for separating the two sides in Jerusalem. The Israeli government and the city's municipality — in conjunction with radical nationalist-religious groups — are planning a ring of new settlements and exclusively Jewish religious theme parks and archaeological sites around the historic core of the walled Old City in East Jerusalem, which would both solidify Israeli control and Jewish historical claims to the holiest parts of the city, as well as permanently change its demographic balance in Israel's favor. Though those plans to extend Israel's grip on the city are slated to be finished by 2020, the policies, infrastructure and bureaucratic momentum are already in place to such an extent that if the Obama Administration fails to restrain the Israeli government now, there may never be another chance to share the city with a Palestinian state, according to prominent Jerusalem lawyer and peace activist Daniel Seidemann. "The window is closing fast," he says. "The Obama Administration hasn't blinked yet. If they do, they can pick another regional conflict to solve, because they are not going to solve this one." (See pictures of life in the West Bank settlements.)

But Israeli author and Jerusalem expert Schmuel Berkowitz suspects that it may already be too late. There are currently about 200,000 Israeli settlers in East Jerusalem, but the government doesn't regard them as settlers, as Netanyahu emphasized in Washington this week. It is doubtful whether any Israeli government could muster either the electoral mandate, or the manpower, to remove them, because there's a broad consensus among Israelis that at least the Old City should remain in their hands. And there are Israelis now so deeply settled in the middle of Arab neighborhoods, sometimes sharing the same building, that any attempt to draw boundaries in the city would likely present a constant source of tension, and even violence. "It's human nature to think that all problems can be solved, but maybe Jerusalem cannot be solved," says Berkowitz.

Meanwhile, extremists on all sides are using the deadlock between Israel and the U.S. to fan the flames in Jerusalem and turn the political conflict into a religious one. Israeli police are having increasing difficulty maintaining the delicate status quo that governs the Old City, whereby each religious group has control of and the exclusive right to pray at their respective holy sites. At moments of political tension, and on religious holidays, radical Israeli groups have been calling for Jews to go and pray on the Temple Mount — which Muslims call the Haram al-Sharif, and is under their control. Jerusalem cops recognize that such a move would be treated by the Palestinians as an extreme provocation.

Palestinian Islamist parties, in turn, have been raising the temperature by calling on young men to turn out in force to "protect" the Muslim sites, claiming that the Israelis are trying to take control of the iconic al-Aqsa mosque and Dome of the Rock. Such gatherings have often turned into riots, with mobs throwing stones at nearby Israelis and tourists. The city's police, invariably, have been caught in the middle, trying to prevent flare-ups and casualties that could spark new rounds of violence. To do so, the police block access to prayers at the Muslim holy sites for men under the age of 50, which further inflames Palestinian passions, as does the heavy police presence required to keep order. It's a vicious cycle, says Jerusalem Police Chief Aharon Franco. "No one knows if there is going to be another intifada, but if there is, it will start in Jerusalem." Just like the last one did, in 2000, after the failure of a previous round of U.S.–led peace negotiations.