(Adds comments by Israeli Arab legislator, paragraphs 12-13)

By Jeffrey Heller

JERUSALEM, Jan 16 (Reuters) - A right-wing party quit Israeli Prime Minister Ehud Olmert's government on Wednesday, condemning his peace talks with the Palestinians and leaving him even more politically vulnerable.

Olmert, who could face new calls to resign later this month when an inquiry into the 2006 Lebanon war issues a final report, had his support in the 120-member parliament cut from 78 seats to 67 after Yisrael Beiteinu's defection.

But he said the loss of the coalition partner would not deter him from continuing to pursue a peace agreement with Palestinian President Mahmoud Abbas.

A statement issued by Olmert's office said he believed the negotiations held "the only real chance of ensuring the peace and security of Israeli citizens".

Strategic Affairs Minister Avigdor Lieberman made good on his threat to pull Yisrael Beiteinu out of the coalition once talks with the Palestinians moved to "core issues" including borders and the fate of Jerusalem and Palestinian refugees.

"A few minutes ago, I spoke to the prime minister and I also gave him a written announcement of our departure from the coalition and my resignation from the government," said Lieberman, whose party appeals to Russian-speaking immigrants.

"Negotiations on the basis of land for peace are a critical mistake ... and will destroy us," Lieberman told a news conference. "It is clear to everyone that these talks will lead to nothing."

Israel and the Palestinians opened their most serious peace talks in seven years on Monday, urged by U.S. President George W. Bush to reach a deal within a year.

But domestic troubles have weakened Olmert and Palestinian President Mahmoud Abbas in their home constituencies, and with a narrower majority in the legislature, the Israeli leader could be more vulnerable to coalition partners' demands.

Lieberman said that instead of making concessions to the Palestinians, Israeli leaders should seek a deal to swap territory and people with a future Palestinian state -- an allusion to Israel's Arab minority that makes up some 20 percent of its population.

"Our problem is not with the Palestinians but with the Israeli Arabs," Lieberman said, comparing two Arab legislators in Israel's parliament to leaders of the Islamist Hamas group.

Ahmed Tibi, an Arab legislator in the Israeli Knesset, called Lieberman's remarks contemptible.

"We are the salt of the earth. He is the immigrant and we will be here long after him," Tibi told reporters. (Additional reporting by Joseph Nasr, Editing by Keith Weir)

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