(Adds Rice quotes, details, paragraphs 7-8, 14-16)

By Arshad Mohammed

JERUSALEM, June 15 (Reuters) - U.S. Secretary of State Condoleezza Rice said on Sunday Israel's settlement building was harming peace negotiations with the Palestinians.

After meeting Palestinian President Mahmoud Abbas -- who called settlements "the highest hurdle" to a deal with Israel -- Rice said an agreement on creating a Palestinian state could be reached this year but that all sides had to work harder.

Making her sixth visit to the region this year to try to push the two sides closer to a deal, Rice suggested she might deepen her own involvement and proposed she hold more three-way meetings with the two top Israeli and Palestinian negotiators.

Disputes over settlements and a corruption scandal that could topple Israeli Prime Minister Ehud Olmert have undercut a U.S. push for a deal before President George W. Bush steps down in January, Israeli, Palestinian and Western officials say.

A spokesman for the Jerusalem municipality said on Sunday that a regional planning board had authorised building at least 2,550 new homes by 2020 in the occupied West Bank in areas that Israel considers part of Jerusalem. That figure includes 1,300 planned units announced over the weekend.

"The actions and the announcements that are taking place are indeed having a negative effect on the atmosphere for the negotiation -- and that is not what we want," she told a news conference with Abbas, pointing to Israeli settlement activity.

Speaking later to American reporters, Rice said it was important to restore confidence that Israel was not trying to "dictate or prejudge" borders, which the United States believes should be determined in negotiations between the two parties.

NO 'BLINDING BREAKTHROUGHS'

Asked if she expected Israel to take action to rein in settlement activity, Rice said: "I don't expect, frankly, any blinding breakthroughs." She later told reporters she had seen no signs of an Israeli change of heart on settlements.

Israel says its settlement projects are consistent with long-standing policies that do not contradict the peace efforts. Palestinians fear the enclaves will deny them a viable state.

"It's clear to everyone that the Jewish neighbourhoods of Jerusalem will remain part of Israel in any possible final status agreement," Olmert spokesman Mark Regev said.

Israel considers all of Jerusalem -- including the eastern part of the city it captured in a 1967 war and annexed in a move that did not gain international recognition -- to be its "eternal and indivisible" capital.

Palestinians want East Jerusalem to be the capital of the state they aim to establish in the West Bank and Gaza Strip.

Israel has repeatedly announced plans to build more homes in Jewish settlements it intends to keep in any peace deal, violating its commitments to halt all settlement activity under a 2003 U.S.-backed "road map" peace plan. The road map also calls on the Palestinians to crack down on militants.

In a string of meetings, Rice held talks with Abbas, Palestinian Prime Minister Salam Fayyad as well as with Israeli Prime Minister Ehud Olmert, Defence Minister Ehud Barak and Foreign Minister Tzipi Livni.

She also had a three-way session with the top negotiators, Livni and former Palestinian prime minister Ahmed Qurei, and proposed holding more to try to reach the end-of-the-year goal, which is now widely viewed as unrealistic.

"We have a lot of work to do between now and then if we're going to get it done. So I expect an intensification of our efforts," she said. "It's June. I expect that people are going to work harder and harder."

Rice said she planned to discuss road map compliance at trilateral talks on Monday morning with Barak and Fayyad.

In the Gaza Strip, the Islamist Hamas group that controls the territory said "nothing good could come from Rice's visit." Hamas, which seized the area from Abbas's Fatah faction in fighting a year ago, opposes his peace talks with Israel. (Writing by Arshad Mohammed and Jeffrey Heller, Additional reporting by Wafa Amr in Ramallah, Ori Lewis, Avida Landau and Adam Entous in Jerusalem, and Nidal al-Mughrabi in Gaza, Editing by Dominic Evans)

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