Blair met Bush for talks in Washington on Friday amid much criticism of US policy towards the Palestinian question and Washinton's handling of a deteriorating situation in Iraq.
Blair told a sun-drenched news conference with Bush that "we welcome the Israeli proposal to disengage from Gaza and parts of the West Bank".
"This is a historic moment," Bush said. "And I think people need to view it as such and seize the moment and help a Palestinian state become a reality, a Palestinian state that can live in peace with its neighbours."
Israeli Prime Minister Ariel Sharon's recently proposed withdrawing Jewish settlements from Gaza while retaining others on the occupied West Bank.
His proposal has drawn outrage from the Palestinians, who point out that all Israeli settlements on occupied land are illegal and should be removed. The Arab world is also opposed to Sharon's plan and many in Europe are sceptical.
But in a major US policy shift, Bush endorsed the plan on Wednesday, while also dismissing key Palestinian demands such as the right of return for refugees or a return to israel's pre-1967 borders.
Blair disagreed with those who feel the plan was a departure from the US-backed "road map" peace plan envisaging a Palestinian state by 2005.
Ariel Sharon (L) has won strong
backing for his plan from Bush
He called on the international quartet sponsoring the "road map" - the United States, the European Union, Russia and the United Nations - to discuss how it can support the Palestinian Authority economically and politically.
A meeting is scheduled on 28 April in Berlin.
Blair said that if Israel followed through on its proposal, "the concept of a viable Palestinian state becomes a real possibility; not something that's put in a document and talked about or discussed in resolutions or speeches, but actually is a real, live possibility."
Meanwhile, against a backdrop of renewed violence in Iraq, the two strong war allies reaffirmed their vow to stand together in Iraq and stick to a 30 June deadline for handing over power to an interim government.
"We stand firm," said Blair. "We will do what it takes to win this struggle. We will not yield. We will not back down in the face of attacks, either on us or on defenceless civilians."
But he added, "It was never going to be easy, and it isn't now."
UN's Lakhdar Brahimi proposes
dissolving the Iraqi Council
And the two leaders also seized on a UN proposal for an interim Iraqi government as a welcome recommendation.
Bush has been criticised this week for not having shed light on what plan he supports for Iraq once sovereignty is transferred on 30 June from a US-led occupation.
The proposal was put together by UN envoy Lakhdar Brahimi to dissolve the Iraqi Governing Council and develop a caretaker government until elections can be held early next year.