Under the agreement, Israel recognises Jordan's claim to be custodian over Jerusalem's Islamic holy sites, underpinning the Hashemites' right to a special role in deciding the city's future status. The move, say Palestinians, is a deliberate ploy by Israel and Jordan to divide and rule Jerusalem, as they have a mutual interest in blocking Palestinian hopes of winning Arab east Jerusalem as a future capital.
These fears are causing growing anger and depair among Palestinians throughout Jerusalem and the West Bank and look certain to spur militancy.
Islamic militants of Hamas have often warned that their fiercest war will be waged over Jerusalem. Israeli security forces last night said they had rounded up dozens of Hamas activists in the West Bank following Wednesday's attack on a bus in Tel Aviv.
Although Yasser Arafat, chairman of the Palestine Liberation Organisation, appears outflanked by the Israeli-Jordanian move, he has some powerful political weapons with which to shore up his Jerusalem claims, and he has recently started to use them. As a result Mr Arafat and King Hussein have already become locked in a battle of wills.
Mr Arafat has forged ahead with his claim to take over the running of Jerusalem's holy sites by setting up a religious ministry. He is also appealing to Palestinians responsible for running holy sites in Jerusalem and the West Bank to give up their ties with Amman and show their loyalty to the PLO.
Jerusalem's religious leaders are angry that King Hussein appears to be dividing the Palestinian camp and thereby playing into the hands of the Israelis. Israel claims Jerusalem must remain united for ever under Israeli sovereignty, while the Palestinians demand east Jerusalem as their capital.
King Hussein has played down Arab political claims in the city in order to shore up his religious role, accepting only limited quasi-sovereignty over the holy sites. For Israel, therefore, King Hussein makes a far preferable partner in the Jerusalem negotiations.
On historic, religious and personal grounds, the Hashemites have for decades claimed an administrative and spiritual authority over the Jerusalem holy sites, namely al- Aqsa mosque and the Dome of the Rock on the Haram al- Sharif - or the Holy Sanctuary - which sits above the Jewish Temple Mount.
Jordan has also maintained an authority over the other Islamic sites in the West Bank.
King Hussein believes deeply that this role is rightfully his, as a descendant of the Prophet Muhammad. The king also knows that without his role in Jerusalem, his position in the Arab world would be severely diminished.
The Islamic waqf, or ministry of religious endowments, was based in Amman during the years of Jordanian rule in the West Bank and Jerusalem, and has remained there since the 1967 Israeli occupation. A month ago Mr Arafat threw down the gauntlet to King Hussein by appointing his own religious minister, Hassan Tahboub, and setting up a Palestinian waqf. Two weeks ago he went further by appointing his own grand mufti for the West Bank and Jerusalem.
In an apparant compromise, King Hussein announced that he would relinquish his right to control the sites in the West Bank and stopped paying the salaries of the 1,230 Muslim staff at the West Bank sites and religious courts. However, the king insisted he would maintain his custodial role in Jerusalem, and pay the salaries of the 540 waqf employees.
Next month Mr Arafat intends to start paying the salaries of the Jerusalem employees and the bills for every Islamic institution, thereby co- opting Jordan's administrative apparatus in the city. Palestinian sources say King Fahd of Saudi Arabia has promised to foot the dollars 12m ( pounds 7.5m) bill.