The two main Palestinian factions, Fatah and the Islamist movement Hamas, appeared on the verge of forming a historic unity government after seven years of bitter rivalry as the Palestinian president, Mahmoud Abbas, named a new prime minister agreed by the two sides on Thursday.

The official announcement brings Palestinians a substantial step closer to a final reconciliation between Abbas's Fatah and Hamas, which set up separate governments in 2007 after Hamas took control of Gaza after a sweeping win in legislative elections, that Fatah and the west refused to recognise.

A new unity government backed by Hamas – even a technocratic one – would be a popular move with Palestinians but poses big challenges both to any attempt to revive a peace process with Israel and to the Palestinian Authority's foreign aid donors including the US, EU and the UK. It could also bring threats of punitive measures from the government of the Israeli prime minister, Binyamin Netanyahu.

Thursday's deadline for naming the new government was set five weeks ago, after Fatah and Hamas agreed to reconcile under a unity administration and the promise of long-delayed elections.

Abbas appointed Rami Hamdallah, prime minister in the West Bank, as chief minister in the new arrangement and said he had asked him to form a government.

In a brief ceremony with Hamdallah by his side, Abbas declared: "This letter designates Dr Rami Hamdallah to form a new transitional government. I wish him luck in this difficult task which he will undertake."

According to Palestinian sources announcement of the full government, which was expected on Thursday, has been held up over disagreements over the posts of foreign and interior ministers and may now be announced next week.

The five weeks of talks to secure a new government followed the surprise announcement of a reconciliation deal as the last round of peace talks between Palestinians and Israelis collapsed amid recriminations. Any unity government that has the backing of Hamas, say both Israeli and western officials, will usher in significant and complex issues.

Netanyahu's rightwing coalition has made clear it will not negotiate with a government backed by Hamas – a group it insists has neither renounced the use of violence nor recognised the state of Israel.

Israel finally suspended US-sponsored peace talks with the Palestinians in April after Abbas agreed the unity pact between his Fatah party and Hamas, which is viewed by Israel as a terrorist group. More widely, any unity deal will pose problems for those in the international community who provide financial and other support to the PA, including the US, which had been planning to give the West Bank and Gaza about $440m in aid in 2014. In the immediate aftermath of the deal a US state department spokesman warned it would have potential implications.

Focus has centred on a 2006 law, passed after Hamas won elections, which explicitly forbids US aid for a "Hamas-controlled Palestinian Authority". That provision is already being interpreted by some in Congress as being applicable to a technocratic government backed by Hamas.

UK aid – particularly support to Palestinian security forces – would face similar issues if, as Hamas has been demanding, any of its own security forces are put on a Palestinian government payroll. Although Abbas has insisted that security co-operation with Israel would continue, part of that has been centred on targeting Hamas on the West Bank.

But there are lingering differences between the Hamas leadership and Abbas. Most serious is whether any unity government would endorse the three "principles" of the Quartet – representing the United Nations, the US, the European Union, and Russia – which insists that any Palestinian government abide by previous agreements, renounce violence and recognise the state of Israel.

The two sides – which have struggled in the past to reconcile on these and other points – have been pushed together by their mutual weaknesses. Abbas's legitimacy, damaged by the failure of the last round of peace talks, will be strengthened by a unity government, while Hamas in Gaza has been struggling under a joint blockade by Israel and Egypt.