Israelis are not renowned for their good manners, but their treatment of Vice-President Joe Biden during his recent visit to their country went beyond chutzpah. Biden is one of Israel's staunchest supporters in Washington, and the purpose of his visit was to prepare the ground for the resumption of peace talks between Israel and the Palestinian Authority. An official announcement that Israel planned to build 1,600 new Jewish settler homes in East Jerusalem scuppered the talks, alienated the Palestinians, and infuriated Biden. It was a colossal blunder that is likely to have far-reaching consequences for the special relationship between the two countries.

America subsidises Israel to the tune of $3bn (around £2bn) a year. America is Israel's principal arms supplier, enabling it to retain the technological edge over all its enemies, near and far. In the diplomatic arena too, America extends to Israel virtually unqualified support, including the use of the veto in the UN Security Council to defeat resolutions critical of Israel. America condemns Iran for its nuclear ambitions, while turning a blind eye to Israel's possession of a large arsenal of nuclear weapons.

This unparalleled generosity towards a junior partner is largely the result of sentimental attachment and shared values. Israel used to present itself as an island of democracy in a sea of authoritarianism. But its own actions have shredded this image to pieces. It is now well on the way to becoming a pariah state. During the Cold War, Israel also used to promote itself as a "strategic asset" in helping to check Soviet advances in the Middle East. But since the end of the Cold War, Israel has become more of a liability than an asset.

America's most vital interests lie in the Persian Gulf; to ensure access to oil, the US needs Arab goodwill. Here Israel is a major liability, as a result of its occupation of Palestinian land and its brutal oppression of the Palestinian people.

There is a broad international consensus in favour of a two-state solution to the Israeli-Palestinian conflict, and America is part of this consensus. A previous Democratic administration provided the most realistic blueprint for such a solution. On 23 December 2000, four weeks before leaving the White House, Bill Clinton unveiled his proposals. He called for the establishment of an independent Palestinian state over the whole of the Gaza Strip and 94 to 96 per cent of the West Bank, with a capital city in East Jerusalem. Both sides rejected this peace plan.

In May 2003, after the invasion of Iraq, the Quartet – America, Russia, the UN, and European Union – issued the "Road Map", which envisaged the emergence of an independent Palestinian state alongside Israel by the end of 2005. This time, the Palestinians accepted the plan with alacrity, whereas Israel tabled 14 reservations that amounted to a rejection. In August 2005, Israel carried out a unilateral withdrawal from Gaza but, far from being a contribution to the Road Map, this was the prelude to further colonisation of the West Bank.

Ever since 1967, Israel has rarely missed a chance to miss an opportunity to make peace with the Palestinians. Its determination to hold on to the West Bank and East Jerusalem translates into rigid diplomatic intransigence. Settlement expansion has been a constant feature of Israeli policy under all governments since 1967, regardless of their political colour. Settlement expansion, however, can only proceed by confiscating more and more Palestinian land. The basic problem is that land-grabbing and peacemaking cannot proceed together: it is one or the other.

The official American position since 1967, except under George W Bush, held that Jewish settlements on occupied Arab land are illegal and a major obstacle to peace. The Obama administration upholds this position. One can make the argument that maintaining the occupation of the West Bank is in Israel's interest, though I utterly reject this argument. But it cannot be argued that the Israeli occupation of the West Bank serves the American national interest. Should America subordinate its own interests to those of its land-hungry ally? A growing number of Americans think not – and some are prepared to say so publicly.

General David Petraeus, the head of Central Command, told the Senate armed services committee last week that the Israeli-Palestinian conflict was a root cause of instability in the Middle East and Asia, and that it "foments anti-American sentiment due to a perception of US favouritism for Israel". In private, Joe Biden told the Israelis that their intransigence was undermining America's credibility with Arab and Muslim nations and endangering American lives in Iraq and Afghanistan.

Small wonder that the announcement of 1,600 new homes in East Jerusalem provoked such intense anger at all levels of the Obama administration. Israeli prime minister Benjamin Netanyahu's apology related only to the timing and not to the substance of the announcement. Hillary Clinton, the Secretary of State, demanded the cancellation of the housing project, a substantial confidence-building measure towards the Palestinians, and a pledge to negotiate on all the core issues of the dispute, including the borders of a Palestinian state. Senator George Mitchell's visit to Israel was postponed.

President Obama correctly identified a total settlement freeze as an essential precondition for restarting the stalled peace talks between Palestinians and Israel, but he allowed Netanyahu to fob him off with a vague promise to exercise restraint for 10 months in building on the West Bank. The promise, however, did not apply to the 3,000 housing units that had already been approved or to East Jerusalem, which Israel had annexed following the June 1967 Six-Day War.

Netanyahu knows that the Palestinians will refuse to resume peace talks unless there is a complete freeze on Jewish house construction there. But he is an aggressive right-wing Jewish nationalist and proponent of the doctrine of permanent conflict. It is because of him and his ultra-nationalist coalition partners that there is no light at the end of the tunnel.

Obama has backed down once, but he is determined to face Netanyahu down this time. His best bet is to use economic leverage to force Netanyahu into meaningful negotiations with the Palestinians on a two-state solution. Even if the current crisis is resolved and the peace talks are resumed, they will go nowhere slowly unless President Obama makes American money and arms to Israel conditional on its heeding American advice.

Avi Shlaim, professor of international relations at the University of Oxford, is author of 'Israel and Palestine: Reappraisals, Revisions, Refutations'