The Justice Ministry said it was drafting an amendment to a 1986 law that forbade contact with the PLO, which Israel has long considered a terrorist organisation.
Yasser Arafat, the PLO chairman, last night welcomed the Israeli move and urged Israel's new government to go further by negotiating directly with the PLO.
Meanwhile in Washington, President George Bush has issued an unofficial invitation to Palestinian leaders from the occupied territories for a meeting in Washington during the forthcoming round of peace talks, according to sources close to the Palestinian peace team.
Faisal Husseini, the leader in the West Bank and Gaza, and Hannan Ashrawi, the spokeswoman for the Palestinian delegation to the peace talks, are expected to accept the invitation. It will be the first meeting between Palestinians and the US President. However, there are fears in the Palestinian camp that the US may use such a meeting to press them into agreeing to Israeli terms for autonomy in the occupied territories.
News of the invitation has emerged as the Israeli Prime Minister, Yitzhak Rabin, meets Mr Bush today at the President's holiday home in Maine in the first US-Israeli summit since Mr Rabin was elected prime minister.
Mr Rabin is hoping that the summit will mark the restoration of friendly relations between the US and Israel and the release of dollars 10bn (pounds 5.2bn) in US loan guarantees, which were frozen because of disagreements between the US and the previous Likud administration. The talks may, however, be marred by the news that the US is prepared to hold direct talks with Palestinian leaders whom the Israeli government prefers to keep at arm's length.
It is understood that the invitation to the Palestinian leaders was made informally by the US Secretary of State, James Baker, during his visit to Jerusalem last month. It is significant that the invitation has been issued in particular to Mr Husseini and Mrs Ashrawi, who are both classified by Israel as east Jerusalem residents.
Israel refused to allow Palestinians residents from east Jersualem to be part of the Palestinian negotiating team, on the grounds that the question of Jerusalem's status should not be on the agenda of the talks. As a result, Mr Husseini and Mrs Ashrawi are not official members of the delegation, although they are the de facto leaders. By agreeing to talk to the two Palestinians, Mr Bush may be attempting to nudge Mr Rabin into taking a more flexible line on the Jerusalem question.
There are high hopes in Israel that Mr Rabin will be able to persuade Mr Bush that the new Labour government has made enough positive moves towards securing Palestinian autonomy in the occupied territories to persuade the President to release loan guarantees, which are much needed to support the stumbling Israeli economy.
Mr Rabin has offered to freeze most Jewish settlements in the occupied territories. The settlement drive by the previous Likud administration was the main reason for the guarantees being withheld. Mr Rabin has said he is committed to achieving autonomy in the occupied territories within nine months. Four weeks of talks on autonomy are due to begin in Washington on 24 August, although both sides are now warning against an early breakthrough.
The Labour government has not offered a total curb on settlements and continues to exclude 'security' settlements, which the Palestinians say is unacceptable. The Israelis and Palestinians remain far apart on the question of the powers of a proposed Palestinian authority during the period of autonomy. Palestinians say they must have a full legislative assembly, while the Israelis say they will agree only to an administrative council.
In addition to seeking a commitment on the loan guarantees in the meeting with Mr Bush today, Mr Rabin will be asking for assurances that the US will continue to ensure the military balance in the Middle East is weighted in Israel's favour. Mr Bush is keen to bring both sides in the peace talks to an early agreement, in order to gain credit for a foreign policy success before the US elections.