Israeli and Palestinian negotiators took on the most contentious issues in their 100-year conflict Monday, under a U.S.-backed effort to hammer out a final peace deal by the end of the year.

The talks' new direction threatened to draw Israeli Prime Minister Ehud Olmert into a coalition crisis, because a key partner has threatened to bolt his government should negotiators broach shared sovereignty over Jerusalem, final borders and Palestinian refugees.

Israeli Foreign Minister Tzipi Livni, Israel's lead negotiator, and chief Palestinian negotiator Ahmed Qureia met at a Jerusalem hotel for the latest round of negotiations. An Israeli official, speaking on condition of anonymity because the meeting was closed, termed the talks "preparatory" but "significant as part of the process."

At a U.S.-sponsored conference in late November, the two sides publicly declared their intention to relaunch negotiations for the first time in seven years, and their hope to reach an agreement before U.S. President George W. Bush leaves office a year from now. But talks have since stalled over friction surrounding Israeli construction in disputed territory and Palestinian militant activity.

Last week, before Bush arrived in the region to try to propel negotiations forward, Palestinian President Mahmoud Abbas and Olmert instructed their negotiators to start discussing the key issues, which have derailed peace talks in the past.

"If we reach an agreement on all these issues, then we can say that we have reached a final agreement," Abbas said in a speech Sunday, where he announced that the core issues would be tackled Monday.

Hawkish lawmaker Avigdor Lieberman, head of the Yisrael Beiteinu Party, has threatened repeatedly to pull out of the coalition if the government begins discussing the questions at the heart of the Israeli-Palestinian conflict. He is due to meet with Olmert on Tuesday to sound out the prime minister on his intentions, Army Radio reported. After the meeting, faction leaders will meet to decide whether to remain in the government, Lieberman spokeswoman Irena Etinger said.

Olmert's government would still command 67 of parliament's 120 seats even if Yisrael Beiteinu's 11 lawmakers were to leave. But the ultra-Orthodox Shas party, which has 12 lawmakers, has also threatened to leave the coalition if Jerusalem comes up for discussion.

Lieberman also opposes Israel's commitment to the U.S. to evacuate some two dozen unauthorized settlement outposts — encampments settlers have erected across the West Bank to break up territory the Palestinians claim for a future state. On Sunday, Olmert told political allies it was a "disgrace" the outposts remained standing four years after Israel promised to pull them down.

Standing next to Olmert at a Jerusalem news conference last week, Bush pointedly said the outposts "ought to go."

Settler leader Pinchas Wallerstein told Army Radio on Monday that settlers would mount "a fierce battle" against any plans to evacuate the encampments, which were built without official authorization, but with the government's knowledge.

Israeli Defense Minister Ehud Barak, whose office oversees settlement activity, has been meeting with settlers for months to try to work out a way to evacuate outposts without stirring up an uproar among settlers and their supporters.

The Haaretz newspaper reported Monday that the settlers have agreed to dismantle 18 of the 26 outposts Israel must evacuate under the U.S.-backed "road map" peace plan, which is serving as the foundation for the renewed talks. Settlers living in the outposts will move to existing settlements, the daily said.

Israel is trying to reach a peace deal with the moderate Abbas government, which controls the West Bank, while fighting Islamic militants in Hamas-run Gaza who fire rockets and mortars at southern Israel almost daily.

Even before Livni and Qureia sat down for their talks, Hamas spokesman Sami Abu Zuhri demanded that Abbas "stop giving away Palestinian blood and rights for free."

"This is a failed meeting that is going to provide a cover for the occupation crimes against our people," Abu Zuhri said in a text message to reporters.

Hamas wrested control of Gaza from Abbas-allied forces in June. The militant Muslim group is isolated internationally and is not a party to the negotiations. Olmert has said repeatedly that Israel would not implement any peace agreement before Gaza militants were subdued.

The head of Israel's Shin Bet internal security agency, Yuval Diskin, told Israeli lawmakers on Sunday that Hamas smuggled in about $100 million (euro67.6 million) to Gaza in recent weeks, the Haaretz newspaper reported. The money was smuggled in by Gazans who traveled to and from Saudi Arabia for a Muslim pilgrimage, Diskin said. The report did not say how he arrived at this estimate.

In violence late Sunday, an Israeli aircraft blasted a car in Gaza City, killing three militants, two from a group linked to Hamas and the other to Fatah, Palestinians said. The Israeli military said the two targeted militants were involved in rocket fire at Israel.