JERUSALEM, May 25 (Reuters) - Israel has failed to locate a soldier abducted to the Gaza Strip almost five years ago, making negotiations with Hamas the only option for retrieving him, the former Israeli armed forces chief said on Wednesday.

The remarks by Gabi Ashkenazi, who retired as top general in February, were a rare disclosure of the extent to which the Palestinian Islamist guerrillas holding Gilad Shalit have managed to outfox Israel's superior military and spy services.

I failed. It must be admitted that we are incapable of employing military force to free Shalit. Hamas is hiding him in such a way that we cannot locate him. We don't know where he is, Ashkenazi said in a speech widely quoted by Israeli media.

If we don't succeed in creating a military option for his release, this has to be honestly acknowledged and a reasonable price should be paid for his liberty, he added.

Hamas-led gunmen seized Shalit in a cross-border raid in June 2006 and have kept him almost entirely incommunicado since.

Through Egyptian and German mediators, Hamas has demanded that Israel free hundreds of jailed Palestinians in exchange for the soldier. Israel agreed last year to release 1,000 inmates but refused to include in the roster senior Palestinian militants convicted of major attacks that killed its citizens.

Both Israel and Hamas say the indirect talks continue.

(Writing by Dan Williams; editing by Mark Heinrich)