In this case, the problem for Israel, and therefore for the U.S., is that the PA has spent the last year doing everything on their "to do" list. Understandably, they expect some pay off. At the same time, the Israeli government, for a variety of reasons, cannot actually comply with key Palestinian demands. This is a problem for the U.S., because the ability to force Israeli compliance is, as the U.S. is discovering, difficult. Steps considered in the west as extremely strong pressure on a long-standing ally are considered weak tea and excuses for Palestinians and the Arab governments in the region. But the PA, at least for the moment, understands that its current diplomatic advantage (and economic well-being) hinges on keeping violence to the "street riot" level (at least in those territories it controls).
Some more behind the cut.
Here's the list of problems from the Israeli side:
1. The Israeli government is fairly weak. Since Sharon had his stroke, there is no political figure or party in Israeli politics that comes even close to commanding substantial confidence among even a plurality of the Israeli public. This is true at the local level as well as the state level. As a result, different pieces of the Israeli government openly fight with one another, and the divided central government cannot get its act together around any approach or policy initiatives. It can't even set a comprehensive local policy. With civil war (as in Jew v. Jew) a constant low-level concern, most factions of the government are reluctant to push too hard even if they could. At the same time, the growing Arab Israeli population produces a continued source of anxiety as well.
2. Jerusalem really is a special case. The fact is that the status of Jerusalem really is the kind of thing that nations go to war over. The vast majority of Israelis, including secular Israelis, view the annexation of East Jerusalem as part of the 1980 law on "united Jerusalem" as settling the matter. To the extent there is any unity on any issue in Israel around the peace process that extends to both right and left, it is that Jerusalem (particularly the old city) is going to be on the Israel side of any final border settlement.
That's not just religious/cultural. It also reflects economic realities that the population and industry of Israel are now focused in the Tel-Aviv Jerusalem region, which is as well settled and contiguous as the Baltimore/Washington Metro area. This is why the current Mayor of Jerusalem, a hard-core secular lefty, is focused on developing Jerusalem's Jewish housing.
Meanwhile, Palestinian insistence that "Al Quds" become the capital of an independent Palestinian state has become a non-negotiable demand. This is why Palestinians reject the effort of Jerusalem's secular mayor to buy them off with housing elsewhere. As it becomes clear that even the "land for peace" block considers negotiating Jerusalem's final status as a non-starter, the pressure to reject negotiation (or regard it as merely a tactic until circumstances favor armed struggle again) grows.
In short, both sides correctly perceive that the other regards the status of Jerusalem as a zero sum game in which there can only be one winner and one loser. That doesn't leave a lot of room for compromise.
3. The Palestinian Authority has gotten its act together, and the rest of the world has noticed. Few people really understood the subtlety of Sharon's withdrawal plan. The object wasn't simply to pull back to defensible borders. It was to create an utterly dysfunctional Palestinian state by fragmenting it and creating warring factions. Unfortunately for Israel (or fortunately, if you think creating a failed state next store if bad policy and/or immoral), Sharon stroked out and no one else has been able to carry out the strategy.
The result was the creation of a space where the PA had responsibility for a contiguous block of territory. Israel and the U.S. made clear that the PA would need to do a lot of very hard things: shape up security forces, clean out corruption (Arafat left a hell of a mess) and generally show they could do all that "good government" stuff. As the PA had a lot against -- fairly entrenched corruption, little outside help, an Israeli security force universally hated by the PA population but with which the PA was required to cooperate, and not much raw material for economic development (and, later, a global recession).
Astoundingly, the PA actually managed to pull most of this off. This is attributed to the current Palestinian Authority Prime Minister, Salam Fayyad -- a "technocrat" who has managed to get a fair number of folks in the West Bank that the only hope of recapturing any diplomatic advantage and move the process forward is to halt armed resistance and clean up local government -- which would benefit the Palestinians anyway. While hardly perfect, Fayyad has made credible steps forward in providing for economic and military security.
Which puts Israel in an awkward spot. Because whatever folks in ISreal may think of Fayyad and the willingness of the PA to actually negotiate, it is a significant improvement over the last several years and the rest of the world -- particularly some key allies like Turkey -- want to see the progress acknowledged. However, as noted in Point 1 above, there isn't really a heck of a lot the current Israeli government can do to meet PA demands, given the fractured nature of the government and the Israeli electorate.
Problems from the PA side:
1. No one has a good strategy. Folks in the PA found out the hard way in 2002, and again in 2006, that the rest of the world really does not give a hoot about the, Armed resistance will not trigger invasion from surrounding Arab states, many of whom are not exactly sure that they want Israel eliminated from the picture. Without Israel, the most powerful country in the region is Iran, followed by Turkey. Neither are Arab states, nor are they Sunni states. That causes a lot of angina with neighbors like Jordan, Syria, Egypt and Saudi Arabia -- all of whom have restive minority populations of Shia and non-Arabs. Lebanon would really like a chance to actually rebuild itself as a country, thank you, and did not appreciate hosting the 2006 Israel/Hezbollah face off.
So the PA has a real problem. They can only deliver limited improvements in people's lives unless Israel makes further concessions and other nations start to provide aid and economic development. But the PA is not a good position to force concessions. At the same time, it's government appears to recognize that a return to direct confrontation would trigger massive Israeli retaliation, such as the the Gaza faced in 2006, with very little international backlash. Worse, such a move would forfeit what little economic and political advantage it has gained by the strategy of getting its act together.
2. Fragmented, ungovernable, and expanding population. Meanwhile, the PA faces the problem of an expanding population, weighted heavily to the young, who have increasingly little patience to endure what appears to be an Israeli government unwilling or unable to prevent further settlement expansion or expand economic opportunity or freedom to travel. This does not make for long-term stability.
Problems from the U.S. side.
1. The Obama Administration does not have a lot of levers to press. The plain truth is there isn't much the U.S. can do to a close ally. The U.S. is not going to invade. It is not going to cancel significant arms/aid. Politically, the Obama Administration can't do it even if it wants to. But more importantly, there is a limit to how much "hard ball" the U.S. plays with its allies. Israel has a fairly productive independent economy grounded in generic drugs, tech, and agriculture. It has an increasing range of trading partners such as China, India and Brazil who -- while always sympathetic to oppressed people, etc., put trade ahead of other considerations. If the U.S. went whole hog and cut all ties with Israel, it would certainly hurt. But Israel could expand its trade (especially tech/weapons trade) with other nations to take up slack. The willingness of the EU and the BRIC group (Brazil, Russia, India, China) to play hard ball with Israel is directly proportional to its closeness with with U.S. So the harder the U.S. pushes, the more likely BRIC and EU will try to detach Israel from the U.S. hegemony side to their own.
Besides, even if the U.S. wanted to do something totally ridiculous, like blockade Israel for violations of tech transfer agreements (if such a thing occurred), it would have a tough time doing it. We are fighting two wars, after all.
2. The U.S. does not want to encourage Arab military action. The U.S. has to consider the extent to which parties which would like to see Israel eliminated (e.g., Iran) will draw the wrong conclusion from a downturn in U.S. relations. Lets ignore Syria and Libya, who are mostly trying to stir up trouble. The problem is more serious with Hamas, Hezbollah and Iran. If any of these parties really believed the U.S. would withdraw its protection and close alliance with Israel, they would seize the moment for armed conflict. So the U.S. is not likely to take any steps that could be interpreted as seriously impacting Israeli security, or backing away from its military commitment to Israeli security.
3. Domestic politics further limit U.S. options. There are a lot of non-progressive Democrats and independents who generally think of Israel as the "good guys" in the Middle East. Sure, a lot of them are Rs rather than Ds. But it applies for a fair number of Ds as well. Push too hard, especially if Palestinian violence follows, and the Obama Administration will face significant political consequences. Since this includes a lot of unknowns, this further limits the strategic options.
As usual, it adds up to a pretty bleak and depressing picture with no good solution for anyone.