Palestinian Authority President Mahmoud Abbas has ruled out attending indirect "proximity talks" with Israel unless it halts the construction of settlements, BBC reported.
Mr Abbas told an Arab League summit he would not resume negotiations as long as Israel maintained the "status quo" in East Jerusalem and the West Bank.
He was seeking support after Israel appeared to refuse to back down in a row with the US over East Jerusalem.
Meanwhile, Israeli tanks have withdrawn from Gaza after an overnight incursion.
It came after the killing of two Israeli soldiers and two Palestinian militants in the worst fighting in the territory for more than a year.
Hamas said its fighters had been involved in the initial border clash, but insisted their actions were defensive. Israel said it began when its troops spotted militants planting explosives along the border.
Reports said one Palestinian was killed during the Israeli incursion.
'Madness'
In a speech to the Arab League summit in the Libyan town of Sirte on Saturday, President Abbas demanded an immediate end to Israel's building on occupied territory, particularly East Jerusalem.
"We cannot resume indirect negotiations as long as Israel maintains its settlement policy and the status quo," he said.
"Negotiations on the borders [of a future Palestinian state] would be absurd if Israel decides on the ground the border," he added. "We have always said that Jerusalem is the jewel in the crown and the gate to peace."
Nearly half a million Jews live in more than 100 settlements built since Israel's 1967 occupation of the West Bank and East Jerusalem. They are held illegal under international law, though Israel disputes this.
Turkish Prime Minister Recep Tayyip Erdogan, a guest of Libyan leader Muammar Gaddafi, described the Israeli position as "madness".
"This leads Israel to isolation," he told the conference. "By adopting such an attitude, Israel is not only violating international law, but also violating human feelings, conscience and history."
The Arab League's Secretary-General, Amr Moussa, said its member states should prepare for the possibility of the peace process's "complete failure".
"It's time to face Israel. We have to have alternative plans because the situation has reached a turning point," he added.
The UN chief, Ban Ki-moon, meanwhile urged Arab leaders to continue supporting US efforts to revive the peace talks.
He said Jerusalem's significance should be respected, and that the city "should emerge from negotiations as the capital of two states".
The BBC's Rana Jawad, in Tripoli, says this is the first time the UN has specified what it would like to result from the talks about Jerusalem.
The chief Palestinian negotiator, Saeb Erekat, welcomed the statement, telling the BBC it was "the right course for a solution in accordance with international law".
At the end of the two-day gathering in Libya, the Arab League is expected to adopt a new resolution to include a plan to establish a commission of legal advisors to pursue cases in international courts regarding East Jerusalem, our correspondent says.
'Narrowing of the gaps'
Israel's approval two weeks ago of plans for 1,600 new homes in the East Jerusalem settlement of Ramat Shlomo prompted the Palestinians to pull out of the proximity talks mediated by the US special envoy, George Mitchell, which both sides had only just agreed to attend.
Unveiled at the start of a visit to the Middle East by US Vice-President Joe Biden, the decision caused one of the worst crises in US-Israeli ties for decades.
During a visit to Washington last week, the White House tried to persuade Israeli Prime Minister Benjamin Netanyahu to commit to several confidence-building measures to persuade Mr Abbas to return to the talks.
A senior Palestinian Authority official has told the BBC that to re-enter the indirect negotiations it would require assurances that the Ramat Shlomo project would not be implemented for at least three years, and that the Israelis would not "continue to take actions which destroy our credibility".
An Israeli government spokesman said on Friday there had been a "narrowing of the gaps" between Israel and the US, but Mr Netanyahu stressed there had been "no change in Israel's policy on Jerusalem".
In November, Mr Netanyahu announced a 10-month suspension of new building in the West Bank. But his government considers areas within the Jerusalem municipality as Israeli territory and thus not subject to the restrictions.