Israeli settlement construction in the occupied Palestinian territories has proved to be among the most serious irritants in the U.S.-Israel relationship. It is also one of the most significant obstacles to a negotiated settlement. But with direct Israeli-Palestinian negotiations kicking off this week and Israel's partial settlement freeze set to expire in a few weeks, the issue is once again poised to come to the forefront of the Middle East peace process.

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President Barack Obama's administration has already found itself entangled in this issue twice this year -- first when Vice President Joe Biden visited Israel in March, and again when Israeli Prime Minister Benjamin Netanyahu visited Washington later that month. In both cases, Israeli officials announced controversial settlement projects in Palestinian areas of occupied East Jerusalem in a manner that was deeply embarrassing to the Obama administration. During his Israel visit, Biden condemned the settlement construction as "precisely the kind of step that undermines the trust we need right now" in one of the most public manifestations of the perceived rift that had emerged between the United States and Israel since Obama's inauguration.

Israeli settlement construction is also rapidly climbing the ladder of Palestinian concerns. Palestinian leaders vividly recall the long years of negotiations in the 1990s, during which the number of Israeli settlers doubled from 200,000 to 400,000, and now have almost reached half a million. The Palestinian nightmare is that additional years of fruitless talks will provide a stable environment for another major expansion of settlements, which would permanently foreclose the creation of a viable Palestinian state.

From his first day in office, Obama attempted to launch a major effort to restart Israeli-Palestinian negotiations that would begin with an Israeli commitment to freeze all settlement activity. Netanyahu, however, deftly shifted the subject from the West Bank to Jerusalem, on which he had much more support from members of the U.S. Congress and in Israel. In response to U.S. pressure, he issued a partial, 10-month moratorium on settlement construction, which did not include Jerusalem and contained many loopholes, such as the grandfathering of no less than 3,000 settlement housing units deemed to have been started before the freeze began on Nov. 25. This allowed Netanyahu to successfully triangulate between U.S. concerns and the demands of his right-wing coalition partners, but the moratorium will expire on Sept. 26, forcing the prime minister to find another method for remaining in both sides' good graces.

After spending most of last year attempting to get Netanyahu to agree to a complete settlement freeze, the Obama administration came to the belief that the contentious settlement issue was toxic for U.S.-Israel relations and an impediment to the resumption of direct talks. Obama effectively took the issue off the table following the U.N. General Assembly meeting last fall, when he declared that the United States still regarded further settlement activity as illegitimate, but was now focusing on restarting direct negotiations.

The Palestinians, having adopted the U.S. demand for a complete freeze, consequently were placed in an impossible situation. Palestinian Authority President Mahmoud Abbas, after all, was unable to back down on this demand as easily as Obama.

To restart direct talks, the Obama administration therefore needed to find a formula that would allow the Palestinians to return to direct negotiations without a complete settlement freeze. Furthermore, any deal needed to strike a compromise that would prevent the talks from collapsing following the Sept. 26 expiration of the partial moratorium.

Many informed observers have suggested that Obama and Netanyahu reached a private and tacit understanding to resolve this conundrum during the Israeli prime minister's White House visit on July 6. The two leaders may have reached an agreement that Israel need not extend the moratorium but that Israel will still, in practice, restrict building to Jewish areas of Jerusalem and large settlement blocs in the West Bank. These areas are understood by all parties to be the likely subject of a land swap in the event of a final-status agreement. Obama and Netanyahu's deal, as long as it remained unspoken, would preserve Netanyahu's viability with his domestic right-wing constituency while also preventing new land expropriations or incendiary projects in Arab areas of Jerusalem from derailing negotiations.

With the Aug. 20 announcement that direct talks were set to resume, it appeared that all sides were prepared to live with such an arrangement. However, several spoilers on Israel's far right have emerged to try to kill the understanding by making it public. Interior Minister Eli Yishai, Foreign Minister Avigdor Lieberman, and dissidents within the prime minister's own Likud party have strongly opposed any such arrangement and hinted that Netanyahu had privately accepted this formula.

As early as Aug. 11, Yishai told the Jerusalem Post, "I believe that [Netanyahu] will resume building only in the blocs as a gesture" and said he opposed and would try to block any such de facto policy. The same Jerusalem Post article cited sources close to Netanyahu as saying that one of the appeals of such a policy is that it would satisfy both the Labor and Likud parties and that "Netanyahu had made a point of planting trees… in three 'consensus' areas: Ariel, Ma'aleh Adumim and Gush Etzion," suggesting this policy was already being observed in practice.

These strong Israeli public statements on settlements prompted an inevitable but ill-advised Palestinian reaction. On Aug. 23., chief Palestinian negotiator Saeb Erekat made a pronouncement that any resumption of settlement building would lead to a Palestinian walkout from the talks, saying that "Israel has a choice: 12 months of peace, or settlements and no peace. They cannot have both." President Abbas has suggested several times that an extended settlement freeze was once again a precondition for the continuation of negotiations, though that is going to be an extremely difficult policy for the PLO to follow in practice, given the diplomatic costs such a move would entail, especially with regards to its relations with the Obama administration.

For now, Netanyahu appears to have been able to hold off the right-wing offensive. Yet, this episode highlights the pitfalls that the Obama administration will face on the settlements issue as it tries to push negotiations forward in the future. There is a very powerful constituency within Israel -- including within the state bureaucracy -- for settlement expansion. Many observers argue that the pro-settlement constituency in Israel is one of the most effective in the country -- permeating the bureaucratic apparatus that makes day-to-day decisions on settlement construction and using the mechanisms of Israel's parliamentary system to act as kingmakers for prime ministers like Netanyahu who can ill afford to confront them. More importantly, no Palestinian leadership can make the painful compromises necessary for peace while Israel undertakes major settlement expansions.

Both sides can theoretically gain sufficient diplomatic space for the talks to proceed by agreeing to a formula in which Israel only builds within areas generally understood by all parties to be the likely subjects of a land swap. However, it is an open question whether Israel's society and its government are capable of restraining themselves in this manner when such a significant constituency regards settlement expansion as an essential and even sacred duty. As Foreign Minister Lieberman put it on Aug. 25: "There is no reason to continue to freeze settlement.… We've done enough and we got nothing in return."

The Obama administration will need to devise some method for containing the damage from this uncompromising Israeli posture, regardless of the Sept. 26 moratorium expiration. If it is unable to broker a compromise that satisfies its own concerns and that of the Israelis and Palestinians, it will be widely seen in the Middle East as a failure of both U.S. leadership and, more specifically, for the president himself. While the negotiations may or may not survive such a failure, it would be an extremely disturbing omen for the president's ability to broker an Israeli-Palestinian agreement and, more broadly, to succeed in his very ambitious agenda throughout the region.