* Barak and Mitchell to meet in London

* U.S., Israel at odds over Jewish settlement in West Bank

* Settlement issue key to resumption of peace talks

By Jeffrey Heller

JERUSALEM, July 5 (Reuters) - Defence Minister Ehud Barak said he would discuss with a U.S. envoy on Monday a compromise over a peace plan calling for an Israeli settlement freeze and seek ways to promote regional peace.

Barak, who last met envoy George Mitchell on Tuesday in New York, travels to London later on Sunday for another round of talks aimed at narrowing a rift with U.S. President Barack Obama, who has demanded a halt to settlement activity.

He told reporters he was aiming for a "broader understanding with the United States on diplomatic moves, including a comprehensive regional agreement".

Barak said Israel was also seeking "a way to translate" the road map, a 2003 peace plan, into "a path acceptable to us, the United States and others".

After last meeting Mitchell, Barak made a link between any Israeli agreement to limit settlement expansion and progress on Arab states "normalising" relations with Israel.

Barak has publicly raised the possibility Israel might temporarily refrain from starting new building projects -- while continuing many under way -- in settlements in return for initial steps towards a regional peace agreement.

The Israeli proposal falls short of demands by Obama and the Palestinians for a settlement freeze in the occupied West Bank.

Palestinian President Mahmoud Abbas, who has said he has been meeting road map obligations to rein in militants, has made a resumption of peace talks with Israel conditional on a complete cessation of settlement activity.

A senior U.S. official confirmed to Reuters that Washington is asking Arab governments whether they might ease sanctions on Israel if it freezes settlement on land Palestinians want for a state.

But Arab leaders have so far been cool, Western diplomats said, to suggestions they might open their airspace to Israeli airliners, allow roaming calls by Israeli cellphones or let in tourists whose passports show they have also visited Israel.

Obama himself spoke last month in favour of a regional peace settlement that would include not just a deal on a Palestinian state but also an end to decades of confrontation between Israel and states like Saudi Arabia and Syria.

In remarks to his cabinet on Sunday, Israeli Prime Minister Benjamin Netanyahu repeated his conditions for Palestinian statehood.

He said such a state must be demilitarised, Palestinians would have to recognise Israel as a Jewish state and Palestinian refugees would be resettled outside Israel. (Additional reporting by Arshad Mohammed in Washington and Adam Entous and Ari Rabinovitch in Jerusalem, editing by Tim Pearce) (For blogs and links on Israeli and Palestinian news, go to http://blogs.reuters.com/axismundi)

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