Netanyahu, in an address seen as his reponse to Obama, refused to heed the U.S. call for an immediate freeze of construction on lands Palestinians claim for their future state. He also said the holy city of Jerusalem must remain under Israeli sovereignty.
Senior Palestinian officials Saeb Erekat said the plan "closed the door" to negotiations.
Still, it was a dramatic transformation for a man raised on a fiercely nationalistic ideology and who has spent a two-decade political career criticizing peace efforts.
"I call on you, our Palestinian neighbors, and to the leadership of the Palestinian Authority: Let us begin peace negotiations immediately, without preconditions," he said, calling on the wider Arab world to work with him.
Since assuming office in March, Netanyahu has been caught between American demands to begin peace talks with the Palestinians and the constraints of a hardline coalition. With his speech, he appeared to favor Israel's all-important relationship with the U.S. at the risk of destabilizing his government.
Netanyahu laid out his vision in a half-hour speech broadcast nationwide during prime time. He spoke at Bar-Ilan University, known as a bastion of the Israeli right-wing establishment, and his call for establishing a Palestinian state was greeted with lukewarm applause.
As Netanyahu spoke, two small groups of protesters demonstrated at the entrance to the university.
Several dozen hard-liners held up posters showing Obama wearing an Arab headdress and shouted slogans against giving up West Bank territory. Across from then, a few dozen dovish Israelis and foreign backers chanted slogans including "two states for two peoples" and "stop the occupation."
Police kept the two groups apart.
The Palestinians demand all of the West Bank as part of a future state, with east Jerusalem as their capital. Israel captured both areas in the 1967 Mideast war.
Netanyahu, leader of the hardline Likud Party, has always resisted withdrawing from these lands, for both security and ideological reasons. In his speech, he repeatedly made references to Judaism's connection to the biblical Land of Israel.
"Our right to form our sovereign state here in the land of Israel stems from one simple fact. The Land of Israel is the birthplace of the Jewish people," he said.
But Netanyahu also said that Israel must recognize that millions of Palestinians live in the heart of the West Bank, and continued control over these people is undesirable. "In my vision, there are two free peoples living side by side each with each other, each with its own flag and national anthem," he said.
Netanyahu has said he fears the West Bank could follow the path of the Gaza Strip - which the Palestinians also claim for their future state. Israel withdrew from Gaza in 2005, and Hamas militants now control the area, often firing rockets into southern Israel.
"In any peace agreement, the territory under Palestinian control must be disarmed, with solid security guarantees for Israel," he said.
"If we get this guarantee for demilitarization and necessary security arrangements for Israel, and if the Palestinians recognize Israel as the state of the Jewish people, we will be willing in a real peace agreement to reach a solution of a demilitarized Palestinian state alongside the Jewish state," he said.
Netanyahu gave no indication as to how much captured land he would be willing to relinquish. However, he ruled out a division of Jerusalem, saying "Israel's capital will remain united."
Netanyahu also made no mention of uprooting Jewish settlements in the West Bank. Nearly 300,000 Israelis live in the West Bank, in addition to 180,000 Israelis living in Jewish neighborhoods built in traditionally Arab east Jerusalem. He also said that existing settlements should be allowed to grow - a position opposed by the U.S.
"We have no intention to build new settlements or expropriate land for expanding existing settlements. But there is a need to allow residents to lead a normal life. Settlers are not the enemy of the nation and are not the enemy of peace they are our brothers and sisters," he said.
Netanyahu also said the Palestinians must recognize Israel as a Jewish state. The Palestinians have refused to do so, saying it would amount to giving up the rights of millions of refugees and be discriminatory to Israel's own Arab minority.
Erekat said Netanyahu's plan was unacceptable since it effectively imposes a solution on the core issues of the conflict.
"Netanyahu's speech closed the door to permanent status negotiations," he said. "We ask the world not to be fooled by his use of the term Palestinian state because he qualified it. He declared Jerusalem the capital of Israel, said refugees would not be negotiated and that settlements would remain."
Nabil Abu Rdeneh, another Palestinian official, called on the U.S. to challenge Netanyahu "to prevent more deterioration in the region."
"What he has said today is not enough to start a serious peace process," he added.
Netanyahu also came under criticism from within his own government - a coalition of religious and nationalistic parties that oppose Palestinian independence.
Zevulun Orlev, a member of the Jewish Home Party, said Netanyahu's speech violated agreements struck when the government was formed. "I think the coalition needs to hold a serious discussion to see where this is headed," he told Israel Radio.
Israeli media speculated that Netanyahu might turn to the centrist Kadima Party, which heads the parliamentary opposition, to shore up his government if the coalition falls apart.
Kadima, the largest party in parliament, issued a statement denying a report that there had been secret talks with Netanyahu over the matter ahead of the speech.
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