* Peace Now: Chances for two-state solution diminishing
* Settlements issue key to restarting frozen peace talks
By Ori Lewis
JERUSALEM, Jan 10 (Reuters) - Israel's government broke all its settlement-building records in 2011, diminishing prospects for establishing a viable Palestinian state in the occupied West Bank, Israel's anti-settlement activist group "Peace Now" said on Tuesday.
The group's annual report on building in Arab East Jerusalem and the West Bank - land the Palestinians want for a future state along with the Gaza Strip - showed that despite international calls to halt construction, thousands of new homes were being built.
"In 2011 (Israeli Prime Minister Benjamin) Netanyahu broke his government's building records and turned it into a very fruitful year for the settlers and a very sad one for the citizens of Israel," Peace Now director Yariv Oppenheimer said.
"At the current rate of building we will lose the chance for a two-state solution."
A government spokesman said Israel was exercising restraint in settlement building and pointed to a 10-month building freeze in 2010.
"The current Israeli government has been attacked by the political leadership of the settler movement for being the worst ... when it comes to building in the settlements ... we have shown great restraint," spokesman Mark Regev said.
Direct peace talks between the Israelis and Palestinians broke down over a year ago after Israel refused to bow to demands that it cease all settlement building and extend the freeze which it imposed on building in the West Bank.
Jordan is hosting diplomatic efforts to re-start the talks that have been promoted by the Quartet of peace brokers - the United States, European Union, Russia and United Nations.
The Palestinians say settlements would deny them a viable state in the West Bank and East Jerusalem, territories Israel captured in a 1967 war, and in Gaza, which Israel relinquished to Palestinian control in 2005.
Peace Now reported a 20 percent increase in settlement construction during the year and said about 35 percent of 1,850 housing starts were on land beyond a separation barrier Israel is erecting, which is expected to demarcate Palestinian areas.
The report added that building was also underway on another 3,500 houses already begun and it listed continuing work in 142 settlements. It said much of the building was intended for religious Jews who cite biblical links to the land.
Since Israel captured the West Bank, home to about 2.6 million Palestinians, around half a million Jews have settled in the territory. They include 200,000 who live around Jerusalem on land Israel annexed in a move not recognised internationally.
A Palestinian government spokesman said Peace Now's figures were proof of the accuracy of their warnings about settlements.
"(The report) shows the credibility and seriousness of the Palestinian warnings to world," spokesman Ghassan Khatib said.
"By allowing Israel to build ... it will destroy all the opportunities to continue the peace process and it will wreck the opportunity for a two-state solution as these settlements are being built on land that will be part of the future Palestinian state." (Writing by Ori Lewis; editing by David Stamp)