The Obama administration has abandoned efforts to persuade Israel to halt settlement building before talks with Palestinians can resume, admitting defeat in a policy it has championed for more than a year.

The move came after the government of Benjamin Netanyahu turned down an offer that US officials characterised as extraordinarily generous.

As part of its effort to convince Israel to revive a lapsed moratorium on settlement building in the occupied West Bank, Washington offered diplomatic and military incentives – including the transfer of 20 advanced F-35 fighter jets.

The continuing expansion of Jewish settlements on occupied Palestinian land is widely seen as a key obstacle to a peace deal and Palestinian leaders insist that they will not hold talks with Israel while building continues.

“We’ve determined that a moratorium will not at the moment provide the best basis for negotiations,” said a US official.

“We know that everyone remains committed to the goal of a framework agreement, including the Israelis and the Palestinians and we will continue to engage with them on the core issues and we still hope to get them to the talks.”

A second US official said the decision did not amount to a change in commitment to the US goal of a peace deal but instead “a change in the direction getting there”.

The alteration in American policy is likely to deal a further blow to US diplomatic credibility among Palestinians and in the wider Arab world.

“The US has shown that it does not know how to deal with the most rightwing government in Israeli history,” one Palestinian official said after learning of the breakdown in talks between the US and Israel. “The Americans don’t know what to do.”

Since taking office in 2009, the Obama administration has backed Palestinian calls for a settlement freeze to precede the beginning of talks.

US officials spent months last year convincing Mr Netanyahu to put a 10-month partial settlement freeze in place.

That freeze expired in late September. The talks, which had only begun that month, then collapsed.

The US now argues that talks on the basis of a freeze would be hindered by differing expectations on both sides – over the extent of a freeze, what would be negotiated during the moratorium and what would happen afterwards.

But officials do not disguise the fact that the decisive move was Israel’s refusal of the US offer, which would have been in addition to $3bn in military aid that Washington provides for the Jewish state.

Ehud Barak, Israeli minister of defence, suggested on Tuesday that the negotiations over the freeze had collapsed because of the US’s preoccupation with WikiLeaks – an idea that Washington vigorously rejected.

The Israeli government declined to comment.

Meanwhile, Israel reacted angrily to decisions by Brazil and Argentina to recognise an independent Palestinian state according to the 1967 borders.

The move undercuts Israel’s claim to occupied East Jerusalem and highlights the country’s deepening diplomatic isolation. Palestinian officials said other Latin American countries were likely to follow the example set by Brazil last week and Argentina on Monday.

Both governments sent letters to Mahmoud Abbas, the Palestinian Authority president, formally recognising a Palestinian state in the West Bank, Gaza and East Jerusalem.

Uruguay has already promised to recognise a Palestinian state early next year and Paraguay is expected to follow suit.

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