ATLANTA, March 18 (Matthew Bigg - Reuters) - Former US President Jimmy Carter called on Thursday for direct talks between Israel and Palestinians toward a two-state Middle East solution, but said it would take a dramatic shift in Israeli policy.

Carter, who presided over the 1978 Camp David Accords that paved the way for peace between Israel and Egypt, has bluntly criticized successive Israeli governments in the past and has frequently been at odds with US government policy.

In a speech at the Carter Center he condemned as 'very embarrassing' Israel's announcement last week during a visit by US Vice President Joe Biden that 1,600 more homes would be built for Jewish settlers near East Jerusalem.

There was no way the Arab world could accept a Palestinian state without East Jerusalem being shared as its capital, he said. 'But it is going to require a dramatic change in the policy of the present government of Israel,' he said.

Israel regards all of Jerusalem, including the eastern sector captured 43 years ago, as its capital. Palestinians want East Jerusalem to be the capital of the state they hope to establish in the West Bank and Gaza Strip.

It is a tragic situation that we face now. I would say that we have not made any progress in the last year, and in fact we have probably gone downhill in trying to bring peace to the Israelis and to their neighbors, he said.

However, it is appropriate not to give up hope. I think with a strong and determined commitment to the two state solution as spelled out by the international community and others ... peace is still on the table, he said.

Palestinian anger over the new homes, echoed in Washington, has put plans for indirect Israeli-Palestinian talks in doubt.

Carter, 85, who served one term as president from 1977 to 1981, said bringing peace to the Middle East was the top international priority of his post-presidency work.

In a 2006 book, he described Israeli policy in the occupied territories as a system of apartheid.