Netanyahu called for "immediate negotiations for peace without prior arrangements" from the Palestinians, and said he was willing to meet Arab leaders anywhere to discuss the issue.
"I call the leaders of the Arab nations to co-operate with the Palestinians and with us on economic peace," he said.
But the Palestinian Authority based in Ramallah in the West Bank reacted angrily to Netanyahu's demands.
Nabil Abu Rdainah, a spokesman for Mahmoud Abbas, the Palestinian president, dismissed the speech, saying: "Netanyahu's remarks have sabotaged all initiatives, paralysed all efforts being made and challenges the Palestinian, Arab and American positions."
Saeb Erekat, the Palestinians' senior negotiator, called on Obama to intervene to force Israel to abide by previous interim agreements that include freezing settlement activity in the West Bank.
"The peace process has been moving at the speed of a tortoise. Tonight, Netanyahu has flipped it over on its backm," he said.
This is the first occasion that Netanyahu has endorsed the creation of a Palestinian state, but many see a disarmed Palestinian state as handing too much power to Israel.
"Netanyahu did not accept the principle of a two-state solution," Lamis Andoni, Al Jazeera's Middle East analyst, said.
"He reduced the concept of a Palestinian state to that of a demilitarised entity that would remain under Israeli control.
"This is at best a formula to establish a Palestinian Bantustan that will not end the Israeli occupation but would legitimise Israeli control."
'Brothers and sisters'
Israel and the Palestinians relaunched peace negotiations at the Annapolis conference in the US in November 2007.
But the talks made little progress and were suspended during Israel's war on Gaza in December and January.
The Palestinians have said that they will not restart negotiations unless Netanyahu publicly backs the two-state solution and stops the building of Jewish settlements on Palestinian land.
In his speech, Netanyahu briefly defended Jewish settlers, a bloc from which he draws much support, calling them "our brothers and sisters".
He said there would be an end to new settlement building, but vowed that Jerusalem would remain undivided.
Addressing Palestinian, Netanyahu urged them to recognise Israel as a Jewish state.
"Israel is the nation state of the Jewish people and so it shall remain," he said.
Jacky Rowland, Al Jazeera's Jerusalem correspondent, said: "Significantly, it seems like the word 'Palestinian state' was something rather sour tasting that Netanyahu didn't want to have in his mouth.
"It was only at a very late stage in the speech he actually said 'we would be prepared to work towards a real peace agreement to establish an independent state living alongside Israel'. But only then if the Palestinians recognised Israel as a Jewish state and if the Palestinian state was to be completely demilitarised.
"So, heavy conditionality from an Israeli prime minister who didn't seem to actually want to utter the word 'state' at all."
Response to Obama
Netanyahu's speech had been heralded in Israel as a response to the address 10 days earlier by Barack Obama, the US president, to the Muslim world, in which he vowed to pursue a two-state solution to the Israel-Palestinian conflict.
Obama's speech raised fears in Israel at the time that Washington might qualify its support to its ally in a bid to improve its relations with the Muslim world.
But Hady Amr, the director of the Brookings Doha centre, said Netanyahu's speech fell well short of Obama's address.
|Netanyahu's speech on the Middle East had been highly anticipated in the region [AFP]
"Ten days ago, when President Obama spoke, there was so much hope, there was so much vision.
"He spoke about America's failings over the years ... There was none of that in this speech," Amr said.
"I think this is a sad day for the Jewish people, the Palestinian people, the Arab people, the Israeli people, because this speech does not bring us closer to peace.
"What it does is it lays down conditions. I guess it sets the tone that this is not the Israeli government that's going to make peace ... I think it's a sad day for the peoples of the region."
But Mark Regev, the Israeli government's spokesman, defended Netanyahu's speech, noting that the prime minister had clearly signalled his acceptance of a Palestinian state.
Speaking to Al Jazeera from Jerusalem, he said: "Palestinians can bring their positions to the table. We will bring our positions to the table. This [policy speech] is an important move forward. If all the moves are to come from Israel, then this problem will not result in a resolution."