For peace to work, Israel will have to give up most of the West Bank, Palestinians must agree to resettle refugees inside their own state and the two sides must share the holy city of Jerusalem. None of that will come easily - and prospects for peace are hurt by the growing power of extremists and the weakness of leaders on both sides.
Weighing heavily on the Middle East is fear about the influence of Iran and the ascendancy of Hamas militants in the Gaza Strip. After Hamas violently routed the more moderate Fatah movement in Gaza in June, the big question now is whether the West Bank will go the same way.
Israel fretted through a year of angst about Iran's nuclear program only to be told in a new U.S. intelligence report that Iran stopped it four years ago. Israel isn't buying the claim, and is scrambling to convince its allies that Iran remains a major threat to the West.
Hamas' takeover of Gaza paradoxically opened the door to peace talks between Israel and the moderate Palestinian leadership now in charge of the West Bank. Israeli and Palestinian leaders both say they hope to sign a peace deal by the end of 2008.
On Nov. 27, the two sides got together in Annapolis, Md., in the presence of some 45 nations, - including leading Arab states, - to relaunch peace talks that had been stalled during the past seven years of Israeli-Palestinian violence.
All the main players have good reason to go for a deal: Israeli Prime Minister Ehud Olmert wants to undo the damage done by his inconclusive 2006 war in Lebanon, Palestinian President Mahmoud Abbas needs a boost in his showdown with Hamas, President Bush would like to offset his difficulties in Iraq, and moderate Arab states need to counter Iranian-supported extremism.
Working against this new hope is weakness at the top: a Palestinian president who only controls half his territory and struggles to impose order in the part he does control, and an Israeli leader who has done little to confront domestic hawks intent on expanding West Bank settlements and torpedoing any progress toward peace.
While the contours of a peace deal have largely been worked out in past talks - - a Palestinian state in the West Bank and Gaza, shared control of Jerusalem and a recognition of the need to settle the Palestinian refugees - every issue calls for excruciating compromises.
Negotiators will have to figure out how to share Jerusalem, a task that must address key Israeli security concerns and religious sensitivities on both sides; and find a just solution for the Palestinian refugees displaced in Israel's 1948 war of independence without destroying the Jewish character of Israel.
Both Israelis and Palestinians have a growing sense that time is running out.
There will soon be more Muslims than Jews in the lands comprising historic Palestine, and Israel will have to make a deal if it hopes to remain both Jewish and democratic. And without peace, moderate Palestinians will likely lose their life-or-death struggle against the extremists.
"If things don't work out it means that the voices that are not in favor of ... a peaceful resolution of the conflict will feel vindicated and they will be strengthened and empowered," said independent West Bank lawmaker Hanan Ashrawi.
Israeli Cabinet Minister Ami Ayalon went further, saying that if peace talks fail "we shall see Hamas controlling the West Bank and the right wing will control Israel."
Israel might sign some sort of a peace treaty in the coming year. But it's highly unlikely the deal would be implemented unless Israel is assured that the lands it evacuates won't be used as launching grounds for attacks, - as happened after Israel withdrew from the Gaza Strip in 2005.
In hopes of bolstering Abbas' forces in the West Bank, the international community is expected to pledge almost $2 billion a year in aid for the next three years to help rebuild the Palestinian economy and security forces.
There are no clear plans for Hamas-ruled Gaza, which is internationally boycotted and can expect to remain almost completely isolated and slide deeper into poverty as long as the Islamic militants remain in power.
If the U.S. change of assessment on Iran was one year-end surprise, Syria is another.
The country has long been under U.S. pressure over its role in Lebanon and Iraq, and in September Israeli warplanes struck a site in Syria that some believe was a nascent secret nuclear site, an accusation denied by Damascus.
But Syria improved ties with the U.S. by attending the Annapolis conference, a thaw that U.S. officials hope will dilute Iran's influence in the region. Damascus, in turn, is hoping the next year will see a resumption of stalled negotiations with Israel over the disputed Golan Heights.