Acknowledging that the settlements are "a major bone of contention," Obama said he believed that it would be sensible, if politically difficult, for Netanyahu to extend Israel's self-imposed moratorium in new settlement building when it expires on Sept. 26.
"It makes sense to extend that moratorium so long as the talks are moving in a constructive way," Obama said at a White House news conference.
"Ultimately the way to solve these problems is for the two sides to agree what's going to be Israel, what's going to be the state of Palestine. And if you can get that agreement, then you can start constructing anything that the people of Israel see fit in undisputed areas," Obama said.
The comment marked Obama's first direct mention of the settlement moratorium, which many analysts say threatens to derail the new Mideast peace negotiations almost before they've begun.
Netanyahu met Palestinian President Mahmoud Abbas in Washington last week, ending a 20-month hiatus on direct peace talks that Obama hopes will yield a deal within a year for an independent Palestinian state alongside Israel.
Despite widespread skepticism over the chances for success, the two leaders agreed to meet again every two weeks. The next session will be in Egypt on Sept. 14, with US Secretary of State Hillary Clinton also attending.
But Israel's decision on the moratorium looms. Abbas has said he may drop out of the talks if the freeze is not extended, but Netanyahu — whose governing coalition is dominated by pro-settler parties — has appeared reluctant to take that step.
Obama said on Friday he saw "enormous hurdles" ahead in the negotiations, but said it was a risk worth taking and the United States would remain engaged even if talks break down.
"The two parties need each other. That doesn't mean it's going to work. Ultimately it's going to be up to them," Obama said.
"I remain hopeful but this is going to be tough," Obama said. "It's a risk worth taking because the alternative is a status quo that is unsustainable. And so if these talks break down, we're going to keep on trying."
Abbas has repeatedly called for a total freeze on the expansion of settlements Israel has built on land it captured in the 1967 war, arguing that the creeping development threatens the integrity of a future Palestinian state.
Netanyahu declined to impose a blanket freeze, but did agree to a 10-month halt to new housing starts in West Bank settlements — a step Obama said on Friday had led to significant reduction in new construction.
Obama said he had urged Abbas to take steps to demonstrate his sincerity in taking part in the peace process, saying this could help Netanyahu take the politically difficult decision to extend the moratorium.
The key US objective now, Obama said, was "to make sure that President Abbas and Prime Minister Netanyahu start thinking about how can they help the other succeed, as opposed to how do they figure out a way for the other to fail."
Obama repeated that the United States remained committed to finding a final deal, which he said could "change the strategic landscape in the Middle East" and help US efforts to pressure Iran over its nuclear program.
"This is something in our interests. We're not just doing this to feel good. We're doing it because it will help secure America as well.
