Palestinian leader Yasser Arafat is responding cautiously to President Bush's proposal for a provisional Palestinian state ruled by a "new and different Palestinian leadership."

Arafat said that only the Palestinian people can decide whom their leaders should be, but added that the speech represented "a serious effort to push the peace process forward."

Israeli Prime Minister Ariel Sharon's office said it found many favorable elements in the president's speech, adding that "genuine reforms and a new leadership" could clear the way to a diplomatic settlement.

On Monday, Bush told the Palestinian people that the United States could help them achieve the goal of statehood in three years if they elect "leaders not compromised by terror."

"It is untenable for Israeli citizens to live in terror. It is untenable for Palestinians to live in squalor and occupation. And the current situation offers no prospect that life will improve," Bush said in a Rose Garden speech, surrounded by National Security Adviser Condoleezza Rice, Secretary of State Colin Powell and Secretary of Defense Donald Rumsfeld.

"Peace requires a new and different Palestinian leadership so that a Palestinian state can be born," Bush said.

In his long-anticipated speech, Bush said "reform must be more than cosmetic changes or a veiled attempt to preserve the status quo" if the Palestinians are to fulfill their aspirations for a state alongside Israel.

Elections should be held by the end of the year for a legislature with normal authority and there must also be a constitution, Bush said.

"When the Palestinian people have new leaders, new institutions and new security arrangements with their neighbors, the United States of America will support the creation of a Palestinian state, whose borders and certain aspects of its sovereignty will be provisional until resolved as part of a final settlement in the Middle East," Bush said.

As for the Israelis, he said they should withdraw to positions they held on the West Bank two years ago and stop building homes for Jews on the West Bank and in Gaza. Ultimately, he said, Israel should end its occupation by negotiating a settlement based on U.N. resolutions and withdrawing to "secure and recognized borders."

Speaking against the backdrop of persistent terror attacks on Israel, Bush said Palestinian authorities were encouraging terrorism, not opposing it.

"This is unacceptable. And the United States will not support the establishment of a Palestinian state until its leaders engage in a sustained fight against the terrorists and dismantle their infrastructure," Bush said.

Senior administration officials said they envision the Palestinians being able to reach provisional statehood within 18 months and full permanent statehood in as soon as three years.

"With a determined effort, this state could rise rapidly — as it comes to terms with its neighbors on practical issues such as security," Bush said.

Israeli Communications Minister Reuven Rivlin, a close ally of Sharon, interpreted Bush's formula as calling for the Palestinians to make the first moves. Rejecting a provisional state, Rivlin said Bush's proposal represented a "vision of bringing the Palestinian people to democracy and reform, and then to negotiate."

A senior Palestinian official said only Palestinians can choose their leadership — and already have in Arafat. "President Bush must respect the choice of the Palestinian people," said Saeb Erekat, an Arafat aide.

Though his meaning was plain, Bush never spoke Arafat's name.

Israel also has a large stake in the success of a democratic Palestine, he said. "A stable, peaceful Palestinian state is necessary to achieve the security that Israel longs for."

Touching delicately on the thorniest issues, the president said Jerusalem's future and the plight of refugees must be addressed. But he offered no prescription.

"You have lived too long with fear and funerals," he said.

Bush said he understood how the Palestinian people could feel like pawns in the Middle East conflict. "You deserve democracy and the rule of law," he said. "You deserve a life for your children and an end to occupation."

The president announced in an April Rose Garden speech that his administration would try to mediate the Israeli-Palestinian crisis.

Two administration officials said that the secrecy surrounding Bush's address was driven in part by a fear that announcing the address could trigger a suicide bombing.

Terms of a provisional state and its international functions were left for negotiations between a reformed Palestinian leadership and Israel.

Bush said the United States, European Union, World Bank and International Monetary Fund stand ready to help oversee reforms in Palestinian finances.

"The United States, along with our partners in the developed world, will increase our humanitarian assistance to relieve Palestinian suffering," he pledged.

Powell already was in consultation with Arab and Palestinian officials as the Bush plan was developed and is likely to return to the region for direct talks, a senior administration official said.

Bush will discuss his initiative with leaders of industrialized democracies at a G-8 meeting this week. Meanwhile, with intense conflict in the Middle East, the idea of a peace conference is being put on hold, another senior official said on condition of anonymity.

The administration also renewed its support for Israel's self-defense, even as Israeli tanks encircled Arafat's badly damaged headquarters in Ramallah and Israel went on the offensive against Hamas militants in Gaza.

On Capitol Hill, Senate Majority leader Trent Lott, R-Miss., said Bush had sent a "strong message to the Palestinians that the way to peace is not paved with acts of terror."

Senate Majority Leader Tom Daschle, D-S.D., called Bush's proposal "a beginning of a long and difficult process, not the end."

Fox News' Wendell Goler, Jennifer Griffin, Teri Schultz, and the Associated Press contributed to this report.