Prime Minister Ariel Sharon had said last month that Israel could hinder voting in the occupied West Bank if the elections were contested by Hamas, which is sworn to destroying Israel and has spearheaded a Palestinian uprising.
But when asked on Sunday whether Israel planned to obstruct the election if Hamas took part, Justice Minister Tzipi Livni said: "It is not in Israel's interest. It is in the Palestinian interest that Hamas takes part in elections."
An official in the prime minister's office said Israel would not impede the election, though it would also not assist the Palestinians to hold the ballot if Hamas ran.
The apparent change followed a lead set by the United States, Israel's key ally, after a White House meeting last week between President George Bush and Palestinian President Mahmoud Abbas, who wants to bring Hamas closer to the political mainstream.
An administration official said the United States still saw Hamas as a terrorist group but it was up to the Palestinians to decide who could take part in the election - the first that Hamas plans to contest. It had boycotted the previous vote in 1996.
"It is not in Israel's interest. It is in the Palestinian interest that Hamas takes part in elections."
The United States hopes to use the momentum from Israel's withdrawal from the occupied Gaza Strip in September to revive negotiations on a "road map" for Palestinian statehood.
Abbas has shied from disarming groups such as Hamas, a process that the Palestinians are meant to start under the road map. But he has said that Hamas will no longer need to keep its weapons after elections.
Hamas, following an eight-month-old truce, has rejected any suggestion that it will disarm.
Hamas spokesman Sami Abu Zuhri said any change in the Israeli position on the election was "just for public relations". He accused Israel of hampering the ballot already by arresting hundreds of suspected fighters, including many Hamas members, in the West Bank.
Sharon has not fulfilled his promise
to freeze West Bank settlements
Polls indicate that Hamas has about 30% support among Palestinians. Its charity network and perceived lack of corruption, as well as its bombings, have won it support at the expense of the dominant Fatah movement.
Livni said that there could be no question of Israel negotiating with Hamas for now and that the group had to show that it had changed.
"As far as we are concerned, Hamas must make a decision now - either to participate in politics or to continue to be a terror organisation," he said.
Israel has said there will be no talks on Palestinian statehood unless armed groups are disarmed, but it has also not met its road map commitment to freeze West Bank settlement building.
The quasi-government Jewish Agency announced on Sunday that it would pay compensation for the first time to the families of Arab Israelis who have been victims of a Jewish "act of terrorism".
The relatives of four Israeli Arabs shot dead on 4 August by a Jewish extremist, who had hoped to sabotage the pullout of troops and settlers from the Gaza Strip, will receive $22,000 (100,000 shekels), the agency said.
"We have decided not to make any distinction between victims of whoever resorted to terrorism"
director of the Jewish Agency
"We have decided not to make any distinction between victims of whoever resorted to terrorism," the agency's director Zeev Beilsky told public radio.
The agency has paid out funds to about 3000 families who have suffered as a result of attacks carried out during the five-year Palestinian uprising.
Sharon immediately classified the 4 August attack in the northern Israeli town of Shfaram as an act of terrorism.
The attacker, who was an army deserter, was lynched by angry residents after opening fire aboard a bus in the town. His shooting failed to make any impact on the Gaza pullout.
Four Israeli Arabs were killed by
an Israeli extremist on 4 August
Israeli Arabs account for 1.3 million of the Jewish state's almost seven million population.
They are the offspring of about 160,000 Palestinians who did not flee or were not expelled from their land after the creation of the state in 1948.