(Adds Palestinian reaction, details)

By Adam Entous

JERUSALEM, Jan 8 (Reuters) - Israeli and Palestinian leaders agreed on Tuesday, on the eve of a visit by President George W. Bush, to begin peace talks on the thorniest issues despite major differences over Jewish settlement construction near Jerusalem.

Israeli Prime Minister Ehud Olmert and Palestinian President Mahmoud Abbas, in a two-hour meeting in Jerusalem, authorised negotiations on all of the final-status issues, from setting statehood borders to deciding the fate of Jerusalem and Palestinian refugees, Israeli and Palestinian officials said.

Neither side gave a start-date, though Palestinian negotiator Saeb Erekat said the talks would begin immediately.

The Olmert-Abbas agreement was timed to smooth the way for Bush's first presidential visit to Israel and the West Bank, starting on Wednesday.

The first final-status talks in seven years were supposed to get under way soon after a U.S.-sponsored conference in Annapolis, Maryland, in November. But the Palestinians demanded Israel first commit to ceasing all settlement activity, as called for under the long-stalled "road map" peace plan.

Under U.S. pressure, Olmert responded with a de-facto halt to new construction in settlements in the Israeli-occupied West Bank, but he has not called off plans to build hundreds of new homes in an area near Jerusalem known to Israelis as Har Homa and to Palestinians as Jabal Abu Ghneim.

That it took six weeks for the leaders to authorise the start of substantive talks on all the final-status issues underscored the hurdles facing Bush in getting the sides to settle their differences in the 12 months he has left in office.

Olmert's spokesman, Mark Regev, said "it is possible to have agreements in 2008" if both sides meet their commitments under the long-stalled "road map" peace plan.

In addition to calling on Israel to stop all settlement activity, the plan asks Palestinians to crack down on militants.

SECRECY

The final-status negotiations will be conducted largely in secrecy by Israeli Foreign Minister Tzipi Livni and former Palestinian Prime Minister Ahmed Qurie, officials said.

Erekat said the talks would also focus on settlements.

Palestinians see the building of Har Homa as the last rampart in a wall of settlements encircling Arab East Jerusalem, cutting it off from the rest of the West Bank. The Har Homa plan has also drawn rare criticism from the United States.

Regev declined to say if and when separate working groups would be established to tackle water and other issues.

Tensions have flared recently over stepped-up Israeli military incursions into the Hamas-run Gaza Strip, in response to cross-border rocket fire by militants, and raids in the West Bank, where Abbas's secular Fatah faction holds sway.

Israel has vowed to keep up the pressure until Abbas proved he was reining in militants -- a demand Olmert has made a prerequisite for implementing any future peace accord.

It is unclear how Olmert and Abbas can close a deal. Abbas wields little power beyond the West Bank after Hamas seized control of the Gaza Strip in June.

Weakened by the 2006 Lebanon war, Olmert could face new calls to resign at the end of the month when a commission of inquiry issues its final report on the conflict. His coalition government is already under strain over the peace talks.

While Bush has called settlement expansion an "impediment", doubts remain over how much pressure he would be willing to put on key ally Israel to make compromises. (Writing by Jeffrey Heller and Adam Entous; Editing by Stephen Weeks)

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