(Adds Olmert statement)

By Alastair Macdonald

JERUSALEM, May 30 (Reuters) - The speaker of the European parliament used a speech to the Israeli parliament on Wednesday to urge Israel to release funds to the Palestinian Authority and to free dozens of Palestinian legislators it has arrested.

Coupling his plea for the jailed politicians with a call for the release of three Israeli soldiers and a British journalist believed held by Arab militants, Hans-Gert Poettering told the Knesset that Europe stood by Israel and was ready to work to promote new talks to bring peace and security to the region.

"The situation seems critical in a way that it has not for a long time," the German Christian Democrat legislator said.

"The European parliament calls on the one hand for the release of the abducted Israeli soldiers, Ehud Goldwasser, Eldad Regev and Gilad Shalit, as well as of the British correspondent Alan Johnston, and on the other for the imprisoned members of parliament and other politicians, including Education Minister Naser al-Deen al-Shaer, to be released from custody."

Shalit was captured a year ago by Palestinians on the borders of Gaza. Goldwasser and Regev were seized by Lebanese Hezbollah guerrillas, sparking a month-long war. Johnston is a BBC correspondent missing in Gaza for nearly three months.

Israel detained more than 30 Palestinian legislators last year, mostly from Hamas, after the Islamist group won power in polls. In the past week it has seized Shaer and another Hamas minister along with more than 30 other Palestinian officials.

Poettering called for Israel to release some $700 million of Palestinian customs revenue it has collected but not passed on to the Hamas-led Palestinian government.

Israel, the European Union, United States and others have imposed sanctions on Hamas for refusing to renounce violence against the Jewish state.

"The Palestinians need this money to pay the salaries of the teachers and to pay the salaries of the policemen," he said before his speech in parliament. "This is Palestinian money ... This is not money which belongs to others."

The cash should go to Palestinian President Mahmoud Abbas, from Hamas's rival Fatah movement, said Poettering.

But Israeli Prime Minister Ehud Olmert rejected the call.

"The prime minister emphasised that he will not transfer funds to the Palestinian Authority so long as there is concern that the funds will be used for terrorist ends," Olmert's office said in a statement after he held talks with Poettering. The EU parliament speaker also met Abbas in Gaza and Israeli Foreign Minister Tzipi Livni during a visit of several days. He did not meet Hamas officials, he said, calling Abbas the "highest representative" of Palestinians.

"It's President Abbas who counts," he said.

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