* Israel rejects full West Bank settlement freeze

* PM Netanyahu vows no limitations on Jerusalem building

* Palestinians see settlements as threat to statehood

(Adds Palestinian comment, paragraphs 6-7)

By Adam Entous

JERUSALEM, May 24 (Reuters) - Israeli Prime Minister Benjamin Netanyahu on Sunday rebuffed U.S. calls for a full settlement freeze in the occupied West Bank and vowed not to accept limits on building of Jewish enclaves within Jerusalem.

Netanyahu's defiant stance set the stage for a possible showdown with U.S. President Barack Obama, who, in talks with the new Israeli prime minister in Washington last week, pressed for a halt to all settlement activity, including natural growth, as called for under a long-stalled peace "road map".

"The demand for a total stop to building is not something that can be justified and I don't think that anyone here at this table accepts it," Netanyahu told his cabinet, referring to Jewish settlements in the West Bank, according to an official.

Netanyahu said Israel had no plans to set up any new West Bank settlements. But he told Obama, according to the official, that his government "does not accept limitations on building" within what Israel defines as its capital, the Jerusalem municipality, an area that includes Arab East Jerusalem and parts of the West Bank captured in a 1967 Middle East war.

Palestinians want their own state in the West Bank and the Gaza Strip with its capital in Jerusalem. Settlement building in the city is a particularly sensitive issue for both sides.

"What we are interested in seeing is that Israel should implement its obligations under the road map, which includes halting settlement activity and expansion in all its forms," Public Works and Housing Minister Mohammed Shatayyeh said.

He added that if Israel wanted to show it was serious about peace talks with the Palestinians it should stop providing utilities to settlements and deny them state funding.

Netanyahu's comments reaffirmed a position he took in his bid for the premiership in a February election. By natural growth, Israel refers to construction within the boundaries of existing settlements to accommodate growing families.

Obama was expected to prod Netanyahu and Palestinian President Mahmoud Abbas to resume long-stalled peace talks during a major speech in Cairo early next month.

Abbas has ruled out restarting those talks until Netanyahu, whose right-leaning government took office on March 31, commits to a two-state solution and halts settlement expansion.

Obama has surprised Israel with his activism on the settlement issue, but it is unclear how much pressure he will put on Netanyahu to freeze construction entirely, Israeli and Western officials said. Former President George W. Bush called for a freeze but building continued largely unchecked, Israeli anti-settlement advocacy groups say.

Half a million Jews live in settlement blocs and smaller outposts built in the West Bank and Arab East Jerusalem, all territory captured by Israel in the 1967 Middle East War.

The World Court says all are illegal. The United States and European Union regard them as obstacles to peace.

Palestinians see the settlements as a land grab meant to deny them a state in the West Bank and the Gaza Strip.

PEACE TALKS

Mark Regev, a spokesman for Netanyahu, said the fate of existing settlements should be decided in negotiations with the Palestinians. "In the interim period, we have to allow normal life in those communities to continue," he said.

Netanyahu has so far balked at committing to talks with the Palestinians on territorial issues, including settlements.

A senior Israeli official, speaking on condition of anonymity, said Netanyahu's government hoped to sidestep U.S. pressure by committing to uproot smaller hilltop outposts built without official authorisation, a step also set by the road map.

"Moving on outposts is relatively easy" compared to freezing the growth of larger settlements, which Israel wants to keep as part of any future peace deal, the Israeli official said.

Last week, Israel flattened a small outpost near the Palestinian city of Ramallah, but residents returned to rebuild.

Defence Minister Ehud Barak told reporters that Israel would remove more than 20 other outposts, either through negotiations or with force, but gave no timeline. (Additional reporting by Ari Rabinovitch and Allyn Fisher-Ilan in Jerusalem and Mohammed Assadi in Ramallah; editing by Myra MacDonald) (For blogs and links on Israeli politics and other Israeli and Palestinian news, go to http://blogs.reuters.com/axismundi)

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