(Edits throughout)

By Matt Spetalnick and Tabassum Zakaria

JERUSALEM, May 14 (Reuters) - An emotional President George W. Bush pledged that America would remain "Israel's best friend in the world" on Wednesday during a celebratory visit to Jerusalem to mark the 60th anniversary of the Jewish state. His host, Israeli Prime Minister Ehud Olmert, appeared to bring a tear to the president's eye when he called him "a great leader, a great friend". Olmert also held out hope of reaching a peace with the Palestinians before Bush steps down in January.

The warmth of Bush's welcome and his own words for Israelis on a day when Palestinians recall their sufferings at Israel's creation in 1948 will do little, however, to dispel many Arabs' conviction that Washington is too partisan to broker a deal.

A rocket attack from the Gaza Strip that wounded several Israelis at a shopping mall and prompted warnings of an Israeli offensive was also a reminder of problems facing negotiations which Bush helped relaunch toward the end of a two-term presidency marked by intractable conflicts in the Middle East.

Israel later killed two Hamas men in an air strike in Gaza.

Bush condemned "terrorists", including the Iranian allies Hezbollah in Lebanon and Hamas in Gaza. He said Washington would support those Palestinians "who don't share" Hamas's vision.

On a visit earlier this year, he called Israel's hold on the West Bank an occupation that must end. This time he spoke little of the peace process -- though he stressed his view that Israel's democracy should be a model for the whole Middle East.

Noting he will address Israel's parliament on Thursday, he said: "I will talk about the day when I believe every child in the Middle East can live in peace and live in freedom. With trust in the rock of Israel we know that day will come. And when it does, the United States of America will be by your side."

MIXED EMOTIONS

The president and his wife Laura began their three-day visit to Israel at a time when all Palestinians recall the "Nakba", or catastrophe, when half the Arabs of Palestine were driven from their homes as the Jewish state was declared on May 14, 1948.

Arab members of Israel's parliament have said they will stay away in protest when Bush speaks in the Knesset on Thursday.

Palestinian President Mahmoud Abbas will meet Bush in Egypt on Saturday. Though Abbas, who lost control of Gaza last year to Hamas, would not echo an Islamist leader who condemned Bush as a "hypocrite", unwelcome in the Holy Land, he and his allies have indicated discomfort with Bush's trip to Israel.

For Olmert, Bush's visit has provided a distraction from an investigation into his finances that has threatened his survival in office -- and, with it, Bush's hopes for a deal this year.

Olmert has this week been talking up his achievements in the negotiations with Abbas, though Palestinian officials have been less sanguine. On Wednesday, he spoke of "progress ... which we believe, with continued dedication and labour, will come to fruition, hopefully ... within this year, the year 2008".

Echoing speeches from Israeli President Shimon Peres and Jewish American billionaire Sheldon Adelson, Olmert told an audience of Israelis, Americans and international dignitaries, that Bush had distinguished himself by his support for Israel.

"Israel is stronger and safer because we look to the future and we know the United States of America will always remain our closest and most dependable ally," Olmert said.

WARM TIES

Bush hailed his predecessor Harry Truman's decision to recognise the state of Israel 60 years ago, even though Arabs had rejected a U.N. plan to establish Jewish and Arab states in Palestine. Speakers during an evening that included music and dance, recalled U.S. military assistance to Israel since then.

Bush called Israel's founding a "marvellous story" during which Jews "never lost sight of Jerusalem".

"It is a story of how brave pioneers risked everything to redeem the promise of this land," he said.

Such rhetoric jars with Palestinians, more than 4 million of whom are refugees. Many doubt whether they will ever have their own state, a despair that prompted many to vote for Hamas.

The future of Jerusalem is a particular bone of contention. Washington and other powers do not recognise Israel's annexation of the city, where Palestinians want to have their own capital.

On Thursday, Bush will visit the Roman-era Dead Sea fortress of Masada, a symbol for Israel's Zionist founders of courage and aspirations to Jewish statehood. Palestinians will hold two minutes silence and other events to recall the Nakba.

Bush reserved some of his strongest comments for the situation in Lebanon, where Hezbollah briefly took over parts of Beirut in fighting that erupted last week: "This is an Iranian effort to destabilise (Lebanon's) young democracy," Bush said.

He called Israel the "only true democracy" in the Middle East and said it could serve as an example for the region. (Additional reporting by Jeffrey Heller, Adam Entous, Ori Lewis and Nidal al-Mughrabi, writing by Alastair Macdonald)

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