"But I say this clearly and firmly, Iran holding a nuclear weapon is unacceptable for my country."
Sarkozy said that peace with the Palestinians was possible if Israel stopped all settlement activity, lifted the checkpoints that cut up the West Bank, ended a blockade of Gaza and accepted Jerusalem as capital of two states.
"Create the conditions for movement," he told Israeli legislators.
He urged them to back proposals for Israeli settlers to leave the West Bank and receive compensation and re-housing in Israel in return.
"There can be no peace without a halt to settlement activity," he said.
Sarkozy said he was he was prepared to host peace talks and mobilise French troops – without specifying their role – to attain peace.
Ehud Olmert, the Israeli prime minister, in a welcome address, praised Sarkozy but said: "Not always do we see eye to eye on every detail."
Mahmoud Abbas, the Palestinian president, welcomed Sarkozy's comments on the settlement issue, according to Saeb Erekat, a senior aide.
"It's a speech that the Israeli leaders need to listen to," Erekat said.
Israel has vowed to continue construction in settlements it intends to keep in the West Bank. Palestinians fear that this will deny them a viable state in the territory.
In a change from his predecessors, Sarkozy has repeatedly described himself as a "friend of Israel" and fostered closer ties with the country in his first year as president.