Israeli Prime Minister Netanyahu attends a special cabinet meeting marking Jerusalem Day in Jerusalem Thomson Reuters JERUSALEM (Reuters) - Israeli Prime Minister Benjamin Netanyahu's handling of the now-moribund Palestinian peace negotiations drew criticism from both sides of his own coalition on Sunday, and one partner said relations with the United States had plunged to an all-time low.

The censure, aired at a showcase policy conference attended by foreign dignitaries as well as the country's senior politicians, exposed deep rifts in the government but there appeared to be little sign of any imminent collapse.

The next Israeli election is scheduled for 2017 and opinion polls have found no serious potential challenger to the third-term, conservative premier.

Finance Minister Yair Lapid, whose centrist Yesh Atid party is the second-biggest coalition member, said Israel had been too opaque about the extent to which it might cede the occupied West Bank to a future Palestinian state in the U.S.-sponsored talks.

The administration of President Barack Obama has blamed the diplomatic impasse on both its Israeli ally and Palestinian President Mahmoud Abbas, whose surprise reconciliation with rival Hamas Islamists in late April prompted Netanyahu to call off peacemaking.

Washington has since further jarred Israel by offering to work with the new Palestinian unity government soon after it was sworn in last week. Netanyahu is shunning Abbas, demanding he first spurn Hamas.

Addressing the annual Herzliya Conference near Tel Aviv, Lapid said there was an "unprecedented crisis" in Israeli-U.S. relations "brought about by problematic and sometimes disrespectful conduct on our part".

He faulted government funding for Jewish settlements in far-flung parts of the West Bank which he saw going to the Palestinians in the future.

Taking the stage next, Economy Minister Naftali Bennett, whose ultranationalist Jewish Home party is the third-biggest in the coalition and opposes Palestinian statehood, accused the government of sapping Israel's security by "constantly freeing terrorists" from jail in past goodwill gestures to Abbas.

WALKOUT THREATS

Bennett urged Netanyahu to adopt his vision of sweeping Israeli annexations of West Bank settlement blocs and leaving Palestinians with limited self-rule elsewhere in the territory.

Lapid, however, preempted Bennett's call by saying that should Israel try to annex any settlements unilaterally, Yesh Atid "will not only quit the government, it will topple it".

The threat was echoed by Justice Minister Tzipi Livni, head of the centrist Hatnua party and the cabinet member formerly in charge of negotiations with the Palestinians.

Livni, who has taken flak from ministers in Netanyahu's rightist Likud party for meeting independently with Abbas in London in mid-May, sounded an unusually harsh critique of the settlements - which most world powers deem illegal though many Israelis see them as a strategic bulwark and Jewish birthright.

"The settlements do not provide security for Israel. They consume security ... They harm Israeli security," she said at the conference.

Livni argued that the Netanyahu government should "work with the Palestinian government in accordance with Israeli interests". She said that Abbas, who lost control of the Gaza Strip to Hamas's armed cadres during a 2007 civil war, must be told to re-impose his authority over the coastal territory.

"It is true that there is Palestinian unity, and it is true Hamas remains an extremist Islamic terrorist group. We should thus distinguish between this government and Hamas," she said.

Dovish Israeli President Shimon Peres also appeared to be parting with Netanyahu's hardline on Abbas in a very public fashion by meeting the Palestinian leader at a prayer for peace hosted by Pope Francis at the Vatican on Sunday. [ID:nL5N0OP0XX]

The office of Netanyahu, who was not scheduled to speak at Herzliya, declined to respond to the comments on Sunday.

(Writing by Dan Williams; Editing by Sonya Hepinstall)