"In my vision of peace, two people live in good neighbourly relations, each with their own flag ... Neither threaten the other's security," he told his audience at Bar-Ilan University, outside Tel Aviv.
"If we receive this guarantee regarding demilitarisation and Israel's security needs, and if the Palestinians recognise Israel as the state of the Jewish people, then we will be ready in a future peace agreement to reach a solution where a demilitarised Palestinian state exists alongside the Jewish state," he said.
He also called for "immediate negotiations for peace without prior arrangements", 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.
On the critical issue of Israeli settlements where he has received considerable US public pressure in the last few weeks, Netanyahu equivocated.
He said "we have no intention of building new settlements" but added that "there is a need to enable the residents to live normal lives, to allow mothers and fathers to raise their children", rehashing oft-used lines to defend so-called "natural growth" of settlements.
Netanyahu also said Israel would not recognise the right of return for Palestinian refugees, saying that the problem must be solved outside of Israel's borders.
And he said Jerusalem – half of which it occupied in the 1967 Middle East war, the half which Palestinians want for the capital of their future state - would remain undivided, meaning kept in Israeli hands.
Palestinians reject terms
The Palestinian Authority based in Ramallah in the West Bank reacted angrily.
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 back," he said.
US welcomes 'first step'
The White House, however, appeared to endorse the speech, with spokesman Robert Gibbs saying that Obama "welcomes the important step forward in Prime Minister Netanyahu's speech".
"The president is committed to two states, a Jewish state of Israel and an independent Palestine, in the historic homeland of both peoples.
"He believes this solution can and must ensure both Israel's security and the fulfilment of the Palestinians' legitimate aspirations for a viable state, and he welcomes Prime Minister Netanyahu's endorsement of that goal," he said.
Sunday was the first time that Netanyahu endorsed the creation of a so-called Palestinian state, but Lamis Andoni, Al Jazeera's Middle East analyst, said "Netanyahu did not accept the principle of a two-state solution".
"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," she said.
Palestinian leaders have rarely made an issue of Israel's insistence that their future state should not have an army in a position to threaten its neighbour, but they have rejected the demand that they explicitly accept Israel as a Jewish state.
To do so, they have argued, weakens the position of the 20 per cent of Israel's citizens who are Muslim and Christian Arabs, and undermine a key demand for a right of return to what is now Israel for millions of Palestinians classed as refugees since Arabs were forced to flee during Israel's creation in 1948.
Israel and the Palestinians relaunched peace negotiations at the Annapolis conference in the US in November 2007.
|Palestinians say Netanyahu's speech "sabotaged" the peace process [AFP]
But the talks made little progress and were suspended during Israel's war on Gaza last December and January.
The Palestinians have said that they will not restart negotiations unless Netanyahu publicly backs a two-state solution and stops the building of Jewish settlements on Palestinian land.
But it seemed like the words Palestinian state were something rather sour tasting that Netanyahu did not want to have in his mouth, Jacky Rowland, Al Jazeera's Jerusalem correspondent, said.
"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."
Netanyahu's speech had been heralded in Israel as a response to the address 10 days earlier by Obama 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.
Obama has also put pressure on Netanyahu in the last few weeks to back a two-state solution and freeze all settlement building without exception.
But a tough crackdown on settlers could fracture Netanyahu's right-leaning coalition government and Netanyahu defended Jewish settlers in his speech, calling them "our brothers and sisters".
Hady Amr, the director of the Brookings Doha centre, said Netanyahu's speech fell well short of Obama's address.
"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."