(Adds Rice comments)

By Arshad Mohammed

JERUSALEM, June 14 (Reuters) - U.S. Secretary of State Condoleezza Rice faulted Israel on Saturday for settlement building and for not easing more restrictions on Palestinians in the West Bank as she began a Middle East peacemaking trip.

Bitter disputes over settlements and a corruption scandal that could force Israeli Prime Minister Ehud Olmert out of office have undercut U.S. efforts to reach a peace agreement this year, Israeli, Palestinian and Western officials say.

"Look, it's a problem and I think it's a problem that we're going to address with the Israelis," Rice said of Israel's decision to build 1,300 new homes in an area of the West Bank that the Israeli government considers part of Jerusalem.

Palestinian negotiator Saeb Erekat called the Israeli announcement part of "a systematic policy to destroy the peace process", and urged Rice, on her sixth trip to the region this year, to make the issue her top priority.

"It'll certainly be a topic of conversation and I expect to raise it with all of Israel's officials and leaders," Rice, speaking to reporters, said of the newly-announced housing units. "We've said before that this is a time to try and build confidence and this is simply not helpful."

The Israeli Interior Ministry said the new units, planned for the ultra-Orthodox area of Ramat Shlomo, were approved by the regional planning board as part of Jerusalem's master plan.

The area is located on land captured by Israel during the 1967 Middle East war. Israel incorporated it into the municipal borders of Jerusalem in an act not recognised internationally.

RESTRICTIONS

While saying Israel has taken some moves to ease restrictions for Palestinians in the occupied West Bank, notably in the city of Jenin where Palestinian forces have taken greater security responsibility, she said more progress was necessary.

"It's not enough and there certainly and clearly needs to be more," Rice said. "I understand the security considerations as well as anybody, but the obligation was undertaken to improve the lives of Palestinians and we are going to have to work very hard if we are going to make that true in a broader sense."

Analysts believe that the corruption scandal dogging Olmert has dramatically reduced the chances of a statehood deal before U.S. President George W. Bush leaves office in January and could force Rice to consider scaling back her ambitions.

Before Rice's visit, Palestinian Prime Minister Salam Fayyad voiced deep skepticism about a deal this year. "I have a strong feeling that is tantamount to certainty that a solution won't be achieved this year," he said this earlier this week.

"I don't think it helps to express pessimism at this point," Rice said when asked about the remark.

During her visit, Rice will meet Olmert in Jerusalem and Palestinian President Mahmoud Abbas in the West Bank city of Ramallah.

She is also scheduled to have a three-way meeting with their main peace negotiators, Israeli Foreign Minister Tzipi Livni and former Palestinian prime minister Ahmed Qurie, as well as with Fayyad and Israeli Defence Minister Ehud Barak.

Despite Olmert's political difficulties, the administration has said it will continue to press for a peace agreement this year -- the goal Bush announced at a high-profile peace conference he hosted in November in Annapolis, Maryland.

Western, Palestinian and Israel officials have all acknowledged privately, however, that Olmert's corruption investigation could trigger new elections, dimming -- if not snuffing out -- the chances of any deal.

Some analysts said Bush should now concentrate simply on handing over an active peace process to his successor, rather than on striving to produce some kind of a deal that may be impossible to reach given Israel's political uncertainty. (Writing by Adam Entous and Arshad Mohammed; Editing by Michael Roddy)

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