Israel objects to any participation in Palestinian politics by Hamas, which has killed hundreds of Israelis in suicide bombings and other attacks over the past two decades.
In a statement issued by Prime Minister Benjamin Netanyahu's office, the government said it would not hold negotiations with a government "backed by Hamas."
"Instead of choosing peace, Abu Mazen formed an alliance with a murderous terrorist organization that calls for the destruction of Israel," the statement said, referring to a name Palestinian President Mahmoud Abbas is also known by.
The statement said Israel also would respond to Abbas' recent decision to join 15 international conventions "with a series of steps," language that typically refers to financial sanctions against the Palestinians.
Even with the tough stance, Netanyahu left the door open to salvaging negotiations, which are set to expire next Tuesday.
"He still has the opportunity to reverse course, to go to the right direction, to abandon this pact with Hamas," Netanyahu told U.S. broadcaster NBC. "I hope he does it. Because if we encounter a Palestinian leadership and a Palestinian government that is ready to pursue genuine peace negotiations, we're going to be there."
Israel transfers about $100 million in tax and customs money to the Palestinians each month. It has withheld these funds in the past as a punitive measure, money needed to keep Abbas' self-rule government afloat.
Abbas won assurances in recent Arab League meetings that Arab countries would pay $100 million to the Palestinian Authority if Israel freezes the transfers. However, some of the Arab donor countries have in the past not met their aid commitments.
Saeb Erekat, the chief Palestinian peace negotiator, said Palestinian reconciliation is an internal matter.
"Israel had no right to interfere in this issue," he said. He condemned any possible Israeli sanctions as "piracy," saying the tax revenues are Palestinian money.
For U.S. Secretary of State John Kerry, the Israeli decision was the latest — and perhaps final — blow to the peace efforts he has led for the past nine months.
With great expectations, Kerry persuaded the sides to resume peace talks last July after a nearly five-year break.
Initially, he hoped to forge a comprehensive peace deal ending decades of conflict. But after months of fruitless efforts, Kerry scaled back his goals and said he would seek a preliminary "framework" agreement by April, with the goal of extending talks to hammer out the final details.
Despite more than 10 visits to the region, and numerous phone calls with the Israeli and Palestinian leaders, Kerry had to abandon even that more modest goal for simply seeking a way to extend talks.
Speaking to journalists in Washington, Kerry said talks could still go on if both sides make compromises.
The U.S. "will never give up our hope or our commitment for the possibilities of peace," Kerry said.
From the beginning, the negotiations never seemed to get off the ground, frequently devolving into excuses and finger pointing.
The Palestinians — and Kerry — questioned Israel's commitment to peace when it continued to build settlements in the West Bank and east Jerusalem throughout the talks. The Palestinians claim both areas, along with the Gaza Strip, for a future state. Israel captured all three areas in the 1967 Mideast war.
The Palestinians also accused Israel of never presenting a formal peace proposal during the months of meetings.
Israel, meanwhile, accused the Palestinians of intransigence and holding extremist positions. In particular, Netanyahu criticized the Palestinians for refusing to recognize Israel as the Jewish homeland. Abbas said such an endorsement would hurt the rights of Palestinian refugees and Israel's Arab minority.
The talks, already strained, hit a downturn late last month after Israel failed to carry out a fourth and final release of long-serving Palestinian prisoners it had promised at the outset of the talks.
The Palestinians responded by renewing their campaign for international recognition of the "state of Palestine" in international bodies. The Palestinians joined 15 international treaties, triggering Israeli objections that they were bypassing peace negotiations.
Even Israeli hard-liners concede that reaching a deal with Abbas alone would fall short of making peace with all Palestinians. And yet, any attempt at Palestinian reconciliation is opposed by Israel because of Hamas violence.
Abbas took a big gamble in approaching Hamas. The U.S. and the European Union consider Hamas a terrorist group, and could conceivably cut off some of the hundreds of millions of dollars in aid they give the Palestinians each year in response.
Hamas seized control of Gaza from Abbas' forces in 2007, and the Islamic group's control of the area remains a major obstacle to any future peace deal.
And despite the pledges of reconciliation, their deal is far from certain as similar attempts have failed.
The agreement calls for formation of a unity Palestinian government within five weeks, and presidential and legislative elections at least six months after that.
"The path is full of mines, and any mine could destroy the whole process," said Yasser Abed Rabbo, a top aide to Abbas.
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