A week after President Barack Obama's address to the Muslim world, Netanyahu said the Palestinian state would also have to recognize Israel as the Jewish state - essentially saying Palestinian refugees must give up the goal of returning to Israel.
With those conditions, he said, he could accept "a demilitarized Palestinian state alongside the Jewish state."
The West Bank-based Palestinian government dismissed the proposal.
"Netanyahu's speech closed the door to permanent status negotiations," senior Palestinian official Saeb Erekat said. "We ask the world not to be fooled by his use of the term Palestinian state because he qualified it. He declared Jerusalem the capital of Israel, said refugees would not be negotiated and that settlements would remain."
Netanyahu, in an address seen as his response to Mr. Obama, refused to heed the U.S. call for an immediate freeze of construction on lands Palestinians claim for their future state. He also said the holy city of Jerusalem must remain under Israeli sovereignty.
The White House said Obama welcomed the speech as an "important step forward."
Reaction among Palestinians was less enthusiastic reports. In their view, Netanyahu's speech isn't a startling reversal - it's a non-starter, reports CBS News correspondent Richard Roth.
But Netanyahu's carefully framed response to White House pressure to get the peace process moving won't upset most Israelis, according to a leading analyst of public opinion, who believes it may help Mr. Obama talk tough to the Palestinians, Roth reports.
An Israeli official told CBS News that Netanyahu had previewed the speech in a phone call to Vice President Biden, and expected a positive reaction from Washington. The negative reaction from Palestinians won't have been a surprise to Israelis either.
Netanyahu's address was a dramatic transformation for a man who was raised on a fiercely nationalistic ideology and has spent a two-decade political career criticizing peace efforts.
"I call on you, our Palestinian neighbors, and to the leadership of the Palestinian Authority: Let us begin peace negotiations immediately, without preconditions," he said, calling on the wider Arab world to work with him. "Let's make peace. I am willing to meet with you any time any place - in Damascus, Riyadh, Beirut and in Jerusalem."
Since assuming office in March, Netanyahu has been caught between American demands to begin peace talks with the Palestinians and the constraints of a hardline coalition. On Sunday, he appeared to favor Israel's all-important relationship with the U.S. at the risk of destabilizing his government.
But his call for establishing a Palestinian state was greeted with lukewarm applause among the audience at Bar-Ilan University, known as a bastion of the Israeli right-wing establishment.
As Netanyahu spoke, two small groups of protesters demonstrated at the university's entrance.
Several dozen hard-liners held up posters showing Obama wearing an Arab headdress and shouted slogans against giving up West Bank territory. Across from them, a few dozen dovish Israelis and foreign backers chanted slogans including "two states for two peoples" and "stop the occupation."
Police kept the two groups apart.
The Palestinians demand all of the West Bank as part of a future state, with east Jerusalem as their capital. Israel captured both areas in the 1967 Mideast war.
Netanyahu, leader of the hardline Likud Party, has always resisted withdrawing from these lands, for both security and ideological reasons. In his speech, he repeatedly made references to Judaism's connection to the biblical Land of Israel.
"Our right to form our sovereign state here in the land of Israel stems from one simple fact. The Land of Israel is the birthplace of the Jewish people," he said.
But Netanyahu also said that Israel must recognize that millions of Palestinians live in the West Bank, and continued control over these people is undesirable. "In my vision, there are two free peoples living side by side each with each other, each with its own flag and national anthem," he said.
Netanyahu has said he fears the West Bank could follow the path of the Gaza Strip - which the Palestinians also claim for their future state. Israel withdrew from Gaza in 2005, and Hamas militants now control the area, often firing rockets into southern Israel.
"In any peace agreement, the territory under Palestinian control must be disarmed, with solid security guarantees for Israel," he said.
"If we get this guarantee for demilitarization and necessary security arrangements for Israel, and if the Palestinians recognize Israel as the state of the Jewish people, we will be willing in a real peace agreement to reach a solution of a demilitarized Palestinian state alongside the Jewish state," he said.
Netanyahu became the latest in a series of Israeli hard-liners to soften their positions after assuming office. Earlier this decade, then-Prime Minister Ariel Sharon led Israel out of Gaza before suffering a debilitating stroke. His successor, Ehud Olmert, spoke eloquently of the need to withdraw from the West Bank, though a corruption scandal a disastrous war in Lebanon prevented him from carrying out that vision.
Netanyahu gave no indication as to how much captured land he would be willing to relinquish. However, he ruled out a division of Jerusalem, saying, "Israel's capital will remain united."
On Washington's demand that Israel freeze construction in West Bank settlements, Netanyahu dug in, insisting that "there's a need to allow settlers to lead normal lives," Roth reports.
Nearly 300,000 Israelis live in the West Bank, in addition to 180,000 Israelis living in Jewish neighborhoods built in east Jerusalem. He also said that existing settlements should be allowed to grow - a position opposed by the U.S.
"We have no intention to build new settlements or expropriate land for expanding existing settlements. But there is a need to allow residents to lead a normal life. Settlers are not the enemy of the nation and are not the enemy of peace - they are our brothers and sisters," he said.
Netanyahu also said the Palestinians must recognize Israel as a Jewish state. The Palestinians have refused to do so, fearing it would amount to giving up the rights of millions of refugees and their descendants and discriminate against Israel's own Arab minority.
Although the Palestinians have agreed to demilitarization under past peace proposals, Erekat rejected it, saying it would cement Israeli rule over them.
Nabil Abu Rdeneh, another Palestinian official, called on the U.S. to challenge Netanyahu "to prevent more deterioration in the region."
"What he has said today is not enough to start a serious peace process," he added.
In Gaza, Hamas spokesman Sami Abu Zuhri called the speech "racist" and called on Arab nations "form stronger opposition" toward Israel. Hamas ideology does not recognize a Jewish state in an Islamic Middle East and the group has sent dozens of suicide bombers into Israel.
Netanyahu also came under criticism from within his own government - a coalition of religious and nationalistic parties that oppose Palestinian independence.
Zevulun Orlev, a member of the Jewish Home Party, which represents Jewish settlers and other hard-liners, said Netanyahu's speech violated agreements struck when the government was formed. "I think the coalition needs to hold a serious discussion to see where this is headed," he told Israel Radio.
Asked about thethat affirmed President Mahmoud Ahmadinejad's claim to power, Netanyahu said the Iranian threat looms large and in full force. He didn't say much but it's safe to say he didn't think he had to, Roth reports.
Israelis have been saying that, politically, Ahmadinejad's re-election works in Netanyahu's favor, because the person he calls the biggest threat to peace is still in power.