The failure to reach a deal to end the Israeli-Palestinian conflict poses a bigger existential threat to Israel than the Iranian nuclear programme, according a former head of the country's security agency, Shin Bet.

Yuval Diskin, who left office two years ago, criticised the continuing occupation and the growth of settlements in the West Bank, saying a solution based on two states would soon no longer be an option.

"I would like to know that our national home has clear borders and that we hold the people sacred, not the land. I would like to see a national home that is not maintained by occupying another people. I say this even though it's not popular: we need an agreement now, before we reach a point of no return from which the two-state solution is not an option any longer," Diskin said in a speech to mark the 10th anniversary of the Geneva Initiative, a peace plan proposed by Israeli and Palestinian politicians and public figures.

The former security chief, who featured in the Oscar-nominated documentary The Gatekeepers, added: "We cannot live in one state between the Jordan river and the Mediterranean Sea and we cannot treat the conflict as shrapnel in the backside." He was referring to comments by the economy minister Naftali Bennett, who dismissed the conflict as "shrapnel in [the] rear end".

Diskin called for a freeze in settlement expansion, saying that the release of long-serving Palestinian prisoners, agreed by the prime minister, Binyamin Netanyahu, before the current talks began, was "a disgusting and cynical move that was born out of a desire to avoid freezing settlement construction".

Speaking as the US secretary of state, John Kerry, arrived in Jerusalem for a fresh push at unblocking the current talks process, Diskin warned of the consequences of the Israeli government's stance.

"It doesn't seem like the current government is trying to change the direction of the settlement enterprise. Our friends in the world are becoming frustrated with the implementation of the two-state solution. There is immense frustration in the West Bank. The Palestinians are feeling that their state is being stolen from them. The Palestinian masses feel they have no future. We must take into account the link between the Palestinians and their brothers, the Israeli Arabs. The concentration of fuel fumes in the air is such that even a small spark can cause a massive explosion."

Palestinian youths "that were born into occupation are distressed, frustrated and hopeless", he added.

Diskin has repeatedly criticised Israeli government policy since leaving the Shin Bet, which runs security and intelligence operations in the West Bank and Gaza. His comments were dismissed by serving officials as "recycled criticism and self-righteous preaching". Diskin was "out of touch with reality", they said.