Palestinian negotiator Saeb Erekat said that demand could never be accepted, while his colleague Nabil Sha'ath added that the government in Ramallah would not tolerate a partial construction freeze and that the moratorium must also be applied in East Jerusalem.
Senior Palestine Liberation Organization official Yasser Abed Rabo accused Netanyahu of using the proposal to weaken the image of U.S. President Barack Obama in the Middle East.
Rabo also said Netanyahu was begging to destroy the peace process and had made the offer to distract from deliberations on the core issues.
The Palestinian leadership was prompt to reject Netanyahu's proposal when he offered it on Monday.
Nabil Abu Rdainah, spokesman for Palestinian President Mahmoud Abbas, said a return to U.S.-backed peace talks required a freeze on settlement building by Israel and emphasized that:
"The issue of the Jewishness of the state has nothing to do with the matter."
In his proposal, Netanyahu stressed that Israel was willing to make concessions and that a peace deal and a Palestinian state could be achieved if the Palestinians would be willing to recognize Israel as the Jewish homeland.
"If the Palestinian leadership will say unequivocally to its people that it recognizes Israel as the homeland of the Jewish people, I will be ready to convene my government and request a further suspension," Netanyahu said while speaking at the opening of the third session of the 18th Knesset.
Israel has effectively abrogated the Oslo Accords and other agreements that were signed with the PLO since 1993, Palestinian Authority President Mahmoud Abbas was quoted as saying on Monday.
Abbas's remarks were reportedly made during the recent Arab summit in Libya.
The PA, meanwhile, reaffirmed its opposition to a temporary freeze of settlement construction and rejected the idea of US assurances to Israel.
Chief PLO negotiator Saeb Erekat quoted Abbas as telling Arab leaders attending the summit that Israel has also scrapped the PA's political, legal, functional and security authorities in the West Bank and the Gaza Strip.
"President Abbas stressed to the Arab leaders that Israel has effectively cancelled the Oslo Accords and other agreements signed with the PLO," Erekat told Agence France-Presse.
Erekat said that Abbas also made it clear that the first option the Palestinians would consider if the peace talks fail is seeking US and UN recognition of an independent Palestinian state on the pre-1967 borders.
Abbas, who met with the foreign ministers of Spain, France and Finland in Jordan on Monday, briefed them on the outcome of the Arab League summit in Libya and his position regarding the future of the peace talks.
Abbas also sought the backing of the three countries for his intention to unilaterally declare a Palestinian state if the peace process fails.
Following the meeting, Erekat said that Israel alone would be held responsible for the failure of the peace talks if it continued to insist on building in the settlements.
He said that the Palestinians were expecting the US and EU to heighten pressure on Israel to extend the moratorium on settlement construction.
Nabil Shaath, member of the PA delegation to the peace talks, said on Monday that the PA would not return to the negotiating table unless Israel extended the freeze. He also said that the Palestinians would not accept a temporary or partial cessation of settlement construction, like the 10-month moratorium that expired last month.
"What is needed is a full cessation of settlement activities and not a temporary one," Shaath told reporters in Ramallah. "How can settlement continue on the lands that were supposed to be traded for peace?" Shaath said that a freeze should also include Jerusalem.
He also threatened that the Palestinians would dissolve the PA and make Israel responsible for the West Bank and Gaza Strip population if the peace talks failed. This contradicts statements made by Erekat a day earlier. Erekat was quoted as saying that Abbas had no plans to resign or dismantle the PA.
Shaath said that the Palestinians were not interested in returning to the cycle of conflict, "although they maintained the legitimate right to resist the occupation."
The PLO negotiator said that the PA also rejected the possibility that the US would give Israel assurances in return for freezing settlement construction for an additional two months.