Bob Hawke, speaking on Thursday at a global peace forum in Kuala Lumpur, said: "Nothing effective can be done while the festering sore of the Palestinian problem continues.
"This issue is used to encapsulate and dramatise the enemy syndrome, with America and its deemed supporters cast as the villains.
"Everything that has been tried at this point has not worked. If anything, the situation is now in many respects worse than it has ever been."
Hawke said it was crucial to use a new approach to the Palestinian crisis "which cries out for resolution in terms of the aspirations of Palestinians themselves and the security of the region".
He said: "It is not argued that resolving this issue, of itself, resolves the challenge of international terrorism, but that it is a sine qua non for meeting that challenge.
"The political shell of a state without a viable and a vibrant economy is a recipe for even greater disaster."
Hawke said the lack of jobs and dismal living standards for Palestinians "is a breeding ground for despair and worse". He said: "While there is no hope among the young for jobs and a constructive development of their talents, there will be no shortage of recruits for the martyrdom of the suicide bomber."
The US - along with countries in Europe and the Middle East - and the World Bank should help provide the capital, technical and educational expertise and equipment to create a viable
Palestinian state, Hawke said.
He was speaking to about 2000 delegates attending the three-day forum organised by the Perdana Leadership Foundation, which is headed by Mahathir Mohamad, the former Malaysian prime minister.