Israeli PM Pledges 'Painful Compromises' for Peace
But the Israeli leader, in an address before a joint session of Congress in Washington on Tuesday, again vowed his country would not return to its "indefensible" pre-1967 demarcation lines.
During his address, Netanyahu insisted all of Jerusalem and "other places of critical strategic and national importance" would be part of Israel in a future peace deal.
"Israel will be generous on the size of a future Palestinian state but will be firm about where the borders with it are," he told the audience, while also acknowledging parts of the "ancestral Jewish homeland" in the West Bank will be given up in an any agreement.
Netanyahu also called on Palestinian President Mahmoud Abbas to "tear up" his reconciliation agreement with Hamas, saying the Gaza-based militant faction was not "a partner for peace."
Netanyahu reacted angrily to Obama's declaration last week that the United States supports creation of a Palestinian state based on the demarcation lines that existed before the 1967 Six Day War - in which Israeli forces occupied east Jerusalem, the West Bank and Gaza - but with "land swaps" agreed upon by the two parties.
Over the weekend, Obama warned in a speech to a pro-Israeli lobby audience in Washington that the Jewish state will face growing isolation without a credible peace process, but reiterated the United States' support for Israel's security remains "ironclad."
On Tuesday, Netanyahu also challenged Abbas to stand before his people and declare he would accept Israel as a "Jewish state" alongside an independent Palestinian state.
The Palestinians have repeatedly balked at Israel's demands to recognize it as a Jewish state because they view it as a rejection of the "right of return" for Palestinian refugees who lost properties in Israel's formation and victory over Arab forces in 1948.
But Netanyahu accused the Palestinian Authority of fuelling a "fantasy" among its people that Palestinians will flood Israel in a future state, as Hamas continues its calls for Israel's destruction.
'Time is running out' on Iran
The Israeli prime minister began his speech by congratulating Obama for the successful military raid that killed al-Qaeda leader Osama bin Laden, saying "good riddance."
Netanyahu said his country fully supports the recent push for freedom within Arab nations such as Libya and Tunisia, insisting a Middle East "rooted in democracy will be a Middle East of peace."
He added that of 300 million Arabs in the region and in North Africa, only the one million Arabs living in Israel are "truly free."
"This startling fact reveals a basic truth," he said. "Israel is not what is wrong about the Middle East, Israel is what is right about the Middle East."
But Netanyahu also warned lawmakers "time is running out" to deal with the existential threat to Israel by Iran and its "terror proxies" in Gaza and Lebanon, warning that militant Islam backed by nuclear capability "threatens the world."
Netanyahu, who received several standing ovations from the audience, was briefly interrupted by a protester in the gallery, who stood and shouted, "No more occupation, end Israeli war crimes" before being escorted out of the gallery.
The Israeli prime minister said the interruption showed the difference between democracies and the "farcical parliaments in Tehran and Tripoli.
"This is real democracy," he said.
U.S.-brokered negotiations between Israel and the Palestinians have stalled in recent months over continued settlement construction in lands the Palestinians believe should be included in a future Palestinian state.
Netanyahu insisted Tuesday that the status of settlements will only settled by negotiations, but acknowledged any real peace agreement that ends the conflict, some settlements will end up beyond Israel's borders.
Earlier this month, rival Palestinian factions Fatah and Hamas reached a reconciliation agreement following several years of division and fierce fighting - a move Obama has warned poses an "enormous obstacle to peace" because of Hamas's refusal to renounce its calls for Israel's destruction.
Adding to the pressure, the Palestinians intend to launch a bid this fall at the United Nations for support of a unilateral declaration of statehood. But Obama suggested in his speech on Sunday that the United States would use its power to veto any such move at the world body.