JERUSALEM - Israel yesterday rejected a U.S. demand to freeze all construction in West Bank Jewish settlements to encourage Mideast peace talks, deepening a dispute with the Obama administration that has the new Israeli government on edge.

The tensions flared on the same day Palestinian Authority President Mahmoud Abbas was in Washington for a meeting with President Obama. Abbas said a demand for a settlement-construction freeze would top his agenda.

Obama stuck to a hopeful tone yesterday, saying he had pressed Israeli Prime Minister Benjamin Netanyahu on the matter only last week. "I think it's important not to assume the worst, but to assume the best," he said in the Oval Office, sitting alongside Abbas. Obama said Netanyahu needed time to work on the issue back home.

He said he expected Palestinians, too, to uphold their commitments, including enhanced security in the West Bank so that Israelis feel safe there.

Obama said he asked Abbas to reduce anti-Israeli sentiments that can be easily stoked in schools, mosques, and the public square.

Said Abbas: "We are fully committed to all of our obligations."

On Wednesday, using unusually strong language, Secretary of State Hillary Rodham Clinton said the Obama administration wanted a halt to all settlement construction, including "natural growth."

Israel uses that term for new housing that it says is needed to accommodate the growth of families living in existing settlements.

Israeli government spokesman Mark Regev responded yesterday by saying some construction would go on.

"Normal life in those communities must be allowed to continue," he said, noting that Israel had already agreed not to build new settlements and to remove some tiny, unauthorized settler outposts. Regev said the fate of existing settlements would be determined in peace negotiations with the Palestinians.

Obama, like his predecessor, George W. Bush, embraces a multifaceted peace plan that calls for a Palestinian state alongside Israel.

Obama declined to set a timetable for the creation of such a nation, but he also noted, "We need to get this thing back on track."

He pressed Netanyahu in their first White House meeting last week to support creation of a Palestinian state alongside Israel. So far, Netanyahu has balked at that idea.

The growing pressure, coupled with Obama's outreach to the Muslim world, to be underscored by a speech in Cairo, Egypt, next week, has Israelis wondering where they fit into the president's plans.

They are particularly concerned by Washington's efforts to start a dialogue with Iran, Israel's archfoe, after nearly three decades of diplomatic estrangement.

Clinton said Obama told Netanyahu last week that the United States saw stopping settlements as key to a peace deal that would see a Palestinian state created alongside Israel.

"He wants to see a stop to settlements - not some settlements, not outposts, not natural-growth exceptions," Clinton said. "We think it is in the best interests [of the peace process] that settlement expansion cease. That is our position. That is what we have communicated very clearly. . . . And we intend to press that point."

While Israel could flout the U.S. administration, it is wary of a showdown with its most important ally. Netanyahu has been careful to avoid directly rebuffing the Americans, though members of his government have become openly critical.

If Israel refused to halt settlement construction, the United States could reduce economic or military aid, curtail arms sales, or scale back the close strategic cooperation the two countries have, including the sharing of information and joint projects, such as antimissile systems, though such actions would be politically controversial in the United States.

During a cabinet debate on settlement outposts this week, Interior Minister Eli Yishai declared that Israel did not have to "kowtow to every American dictate."

"The American administration regrettably . . . is showing the Arab and Muslim world that it is distancing itself from Israel and shifting toward them," Cabinet Minister Benny Begin lamented during a separate parliamentary debate. "The message is clear. The will is clear."

The United States and much of the world consider the settlements an obstacle to peace because they are built on captured land the Palestinians claim for a future state. But successive U.S. administrations have done little to halt settlement activity.

Now more than 120 settlements dot the West Bank, and Palestinian officials say their growth makes it increasingly impossible to realize their dream of independence.

More than 280,000 Israelis live in the West Bank settlements, in addition to two million Palestinians in the territory. An additional 180,000 Israelis live in East Jerusalem, where the Palestinians hope to establish their capital.

With Washington turning up the pressure to freeze settlements, Israeli officials proposed a compromise earlier this week. In exchange for removing 22 outposts, they would ask the United States to permit new construction in existing settlements. Clinton's remarks followed that proposal.

Obama's active courting of Iran and pressure on Israel to make progress with the Palestinians have only compounded Israeli fears.

Israelis will be anxiously listening to his speech next Thursday in Cairo, where he is to deliver a message to the Muslim world to try to repair relations that frayed under the Bush administration.

Obama will visit Saudi Arabia before he goes to Egypt. He has no plans to stop in Israel, an hour's flight from Egypt, during his swing through the region.

In the West Bank city of Hebron yesterday, a senior extremist of the Hamas group - which rules the separate Gaza Strip and is estranged from Abbas' Fatah group - was killed by Israeli forces after a 14-year manhunt.

Israel's military said it surrounded Abed Majid Daodin's house and called on him to surrender, but he opened fire and troops shot him.

The military said he had recruited and dispatched suicide bombers, including two who killed 10 Israelis and wounded about 100 in 1995.

Hamas vowed to avenge his death. "Our fighters in the West Bank have full freedom to strike any target," the group said.