SIRTE, Libya, March 27 (Lamine Ghanmi/Reuters) - Arab states should prepare for the possibility that the Palestinian-Israeli peace process may be a total failure and come up with alternatives, Arab League Secretary-General Amr Moussa said on Saturday.

The troubled peace process suffered a setback this month when the Palestinians said indirect talks with the Israelis would not take place unless Israel canceled a decision to build 1,600 new homes in a settlement near east Jerusalem.

Underscoring the obstacles to reviving negotiations, two Israeli soldiers and a Palestinian were killed in a clash in the Gaza strip on Friday, the bloodiest fighting in the enclave in 14 months.

Moussa did not say what the alternatives to the peace process might be, but one option is to revive an eight-year-old initiative under which Arab states would normalize ties with the Jewish state in exchange for Israeli concessions on territory.

Others are for the Palestinians unilaterally to declare a state, or to propose a single binational state for Israelis and Palestinians.

Speaking to leaders at an Arab League summit in the Libyan town of Sirte, Moussa said a fresh approach was needed.

We have to study the possibility that the peace process will be a complete failure, Moussa said. It's time to face Israel. We have to have alternative plans because the situation has reached a turning point.

The peace process has entered a new stage, perhaps the last stage. We have accepted the efforts of mediators. We have accepted an open-ended peace process.

But that resulted in a loss of time and we did not achieve anything and allowed Israel to practice its policy for 20 years, he said.


U.N. BACKS TALKS

Earlier this month the Arab League gave its blessing to the Palestinians to conduct proximity talks with Israel, and its stance on whether those negotiations should still go ahead could be decisive.

U.N. Secretary-General Ban Ki-moon said on the sidelines of the summit that he had urged Arab leaders to support proximity talks, despite setbacks on the ground.

There is no alternative to negotiations on a two-state solution. Without that, we risk sliding into despair and the potential for more violence of the kind we have witnessed recently, he told reporters.

At the end of the summit's first day, Egyptian Prime Minister Ahmed Nazif told reporters that the Palestinian issue -- and the proposal to press ahead with the talks with Israel -- would be debated on Sunday.

This summit will be crowned by strong decisions related to current Arab issues, Nazif said.

The alternative to the stalled peace process that is favored by many states in the region is the Arab Peace Initiative, first proposed by Saudi Arabia at an Arab League summit in Beirut in 2002.

Under that initiative, Arab countries would normalize relations with Israel in return for a complete Israeli withdrawal from occupied territories and a fair settlement for Palestinian refugees.

The Arab League chief also said the 22-member organization should start talking to Tehran to address concerns, especially strong among Iran's neighbors across the Gulf, about its nuclear program.

I know there is a worry among Arabs regarding Iran but this situation confirms the necessity of a dialogue with Iran, Moussa said in his speech.

Russian President Dmitry Medvedev, in a message to the summit, said he still supported diplomacy to resolve the dispute over Iran's nuclear program but did not rule out sanctions.

The use of sanctions is not ideal but cannot be excluded, he said. Any sanctions that are imposed should be well calculated and not aimed at the civilian population of Iran, he added.

(Writing by Christian Lowe; Editing by Paul Casciato)