RAMALLAH, West Bank, Oct 1 (Reuters/Tom Perry) - A US envoy concluded talks with Palestinian and Israeli leaders on Friday without agreement on how to keep alive peace negotiations that are on hold due to a dispute over Jewish settlement building.

US envoy George Mitchell said Israeli Prime Minister Benjamin Netanyahu and Palestinian President Mahmoud Abbas had agreed to keep talking indirectly. He has been shuttling between the leaders for the last two days.

US President Barack Obama's drive to end the six-decade old conflict appeared to be faltering just a month after his administration launched the direct talks in Washington.

Both the president and the prime minister have agreed that we will continue our discussions, ongoing in an effort to move forward in this process toward what we all share as a common goal: the establishment of comprehensive peace in the Middle East, Mitchell told reporters in Ramallah.

There remain obstacles. Our determination continues, he said. Earlier in Jerusalem, Netanyahu said: We are making efforts together with Senator Mitchell to continue to hold the talks with President Abbas. We want the talks to continue.

Abbas says he will pull out of the talks unless Israel extends its freeze on new building in Jewish settlements in the occupied West Bank, which expired this week.

Palestinians say the growth of the settlements, on land Israel has occupied since 1967, will render impossible the establishment of a Palestinian state in the West Bank and Gaza Strip -- the stated goal of the peace talks.

Some 500,000 Jews live on territory where the Palestinians aim to establish their state with East Jerusalem as its capital.

Saeb Erekat, the chief Palestinian negotiator, said the United States would continue in their bilateral efforts between us and the Israelis, each separately.

The key to direct talks is in the hand of the Israeli prime minister. We hope that the Israeli leadership chooses peace and not settlement, he said after Mitchell's meeting with Abbas. Mitchell said he would depart for Qatar, then Egypt and Jordan.

Abbas has said he will take no final decision until the Arab League has discussed the issue. There were indications on Friday that the Oct. 4 date for an Arab League consultation would be set back to Oct. 8 at the request of US ally Egypt.

European Union foreign affairs chief Catherine Ashton said after talks with the principals that major powers engaged in the process were very concerned that the ending of the moratorium should not put at risk the possibility of long-term peace.

I have urged Israel to continue the moratorium and allow the talks more time to make greater progress, Ashton said.

PROPOSAL REJECTED

Netanyahu is refusing to extend the construction moratorium and Israeli reports said he had rebuffed a US offer of very generous incentives to persuade him to extend it by 60 days.

Obama has invested major political capital in a bid for a Middle East settlement within a year. Israeli media suggested he was desperate to have Netanyahu agree to keep the talks alive by keeping settlement construction frozen, and was furious at being rebuffed.

A US State Department official denied reports that Obama sent Netanyahu a letter proposing security guarantees, including a continued Israeli troop presence in the Jordan Valley after the creation of a Palestinian state.

But an Israeli official, who requested anonymity, confirmed that the White House made an offer of incentives to Israel as described in the media but these were rejected by Netanyahu.

Israel's Yedioth Ahronoth daily said Obama never signed off on the offer. The security proposals were floated in a paper drawn up last week by Israeli Defence Minister Ehud Barak and White House Middle East aide Dennis Ross, it said. It would have become a presidential letter only if Netanyahu accepted.

Obama succeeded in persuading Abbas to resume direct peace talks with Israel on Sept. 2 after a 20-month hiatus but with no overt guarantee from Netanyahu that the settlement freeze he ordered last November would be extended.

Some Israeli political commentators expressed surprise the proposals had been rejected. But they said Netanyahu was afraid of losing power if he got too far out in front of his own governing coalition, which is dominated by pro-settler parties sceptical of peace deals, including his own right-wing Likud.