His Beatitude, Theophilus III, "Patriarch of the Holy City of Jerusalem and all Palestine, Syria, beyond the Jordan River, Cana of Galilee, and Holy Zion" – to give him his full and ancient title – is nothing if not hospitable.

He interrupts an interview in the tranquil stone-built Greek Orthodox patriarchate in the heart of the Old City's Christian quarter to offer his visitors a tot of excellent 40-year-old Moldovan cognac. He is justly proud of the Church's venerable history here, dating back to Byzantine times. In the wall of his wood-panelled first-floor office there is a copy of the historic document given to his 7th-century predecessor Sophronius by Omar Ibn al Khattab, the Second Caliph of Islam, after his bloodless conquest of Jerusalem in 637 and promising the protection of the holy places. With the Greek Orthodox Church well known, among many other things, for being one of the biggest landowners in the Holy Land, the patriarchate is, in the present incumbent's own words, "one of the largest and most powerful institutions in the land ... a state within a state".

Yet not all has been well within the cloistered calm of the patriarchate, thanks to a row with profound ecclesiastical, financial, and above all political overtones. Two years ago Theophilus was elected by a convincing majority of the synod which had earlier deposed his predecessor, Irinaeus, in an atmosphere of political scandal over property deals made on his watch. But Irinaeus refused to go quietly.

Maintaining that the patriarchate is still rightfully his, Irinaeus remains holed up in an apartment inside the building, guarded by armed Israeli police, together with what his successor describes as "two or three monks totally excommunicated from the patriarchate". Moreover, as Patriarch Theophilus explains, "our bank accounts are frozen" so that money due to the patriarchate "is impossible for us to receive in our own name. It has to go through other channels."

Last Thursday, a senior police officer was called to the patriarchate when Theophilus's lawyers tried to execute a court order seeking to enter the apartment occupied by his predecessor, to make an inventory of icons, documents and other valuables held by Irinaeus which they argue belong to the institution. But despite several hours of argument they were not allowed to do so and on Sunday the order was reversed by the same judge.

Yesterday, the Jerusalem District Court deferred a hearing on an appeal by Theophilus's lawyers until tomorrow. These unholy wars arise because for two years after his election, the government of Israel – unlike those of Greece and Jordan, and the Palestinian Authority – has not recognised Theophilus as the Patriarch. Theophilus says that "the White House recognised us from the outset. I have received a very nice letter from President Bush signed by himself." Last month he declared that the government of Israel had "for the first time interfered in the inner functioning and administration of a spiritual institution and tried directly and indirectly to determine who is going to be the spiritual leader of the Church and the community".

Though he is, at times, coy about using the word, Theophilus's basic charge is that for two years attempts have been made to blackmail him into completing and approving the "unfulfilled" – and in political terms radioactively sensitive – deals made during the tenure of his predecessor. Last month, he detailed his complaints about his treatment by Israel – which he has described as a "humiliation and ridiculousness" – at a meeting with Condoleezza Rice, the US Secretary of State, during her last trip to Jerusalem.

It now looks as if Theophilus's travails may finally be reaching an end. A committee chaired by Israeli cabinet minister Rafi Eitan has now made a landmark recommendation that he should be recognised as patriarch.

The police stance last week shows that the story is by no means over. But the Prime Minister's Office has indicated that subject to checks by government lawyers it is likely that the cabinet will decide as Mr Eitan has advised. It – and the US consulate – will not confirm what the patriarch's allies firmly believe, namely that the path to his final recognition was cleared after irresistible pressure from Ms Rice.

But either way the whole episode sheds unusual light on the extraordinary determination of right-wing Jewish settler groups to make inroads into Arab quarters of the Old City. Ms Rice had reason for concern. If it were to go through it would have the potential to affect any future division between Arab and Jewish neighbourhoods in the Old City. The properties involved are on the north, and Arab, side of the wide road linking the Jaffa Gate with the heart of the Old City. They include the Imperial Hotel, which, while it has seen better days since General Allenby stood on one of its still impressive wrought-iron balconies after taking the city from the Turks in 1917, remains one of the area's landmarks. It has been leased from the Church since the 1940s by the Dijanis, a long-established Palestinian Jerusalem family. In August 2004, however, Nicholas Papadimas, a finance officer who had been given power of attorney by Irinaeus, negotiated a deal with Israeli interests – notably including, says Theophilus, Ateret Cohanim, the Jewish settler organisation most associated with acquisition of property in Arab sectors of Jerusalem. When the negotiations were reported by Maariv in March 2005, outrage spread rapidly among Irinaeus's mainly Israeli-Arab flock even though the then Patriarch maintained – and still maintains – that he knew nothing of the transactions and that Mr Papadimas, a high-liver with an expensive taste in cigars and cars who had by now disappeared, had only been authorised to lease a single store. Reflecting anger among junior clergy and laity, the synod convened two months later and deposed Irinaeus. Theophilus maintains that he swiftly came under pressure to approve the deal which led to the downfall of his predecessor.

The convulsions in the Greek Orthodox Church are hardly simple, of course. The Jordanian government earlier this year threatened its approval of Theophilus's appointment and demanded clarification of land deals in which the Church appeared to be still involved. But it dropped the threat after receiving written assurances from the Patriarch. Meanwhile Irinaeus is fighting a determined rearguard court action, arguing that he himself strongly resisted pressure to ratify them once they came to light despite at least one lawyer representing settlers threatening to put a "nuclear bomb" in the patriarchate unless he agreed.

Nevertheless Theophilus now seems in no doubt that the task of extricating the Church from the fallout of "Jaffagate" while preserving its independence has landed with him. "The partiarchate has been dragged into a political conflict and because of a crisis of leadership became involved in things that were not for the patriarchate."

Some allies of Theophilus – who still profess anxiety that the Eitan committee decision may not spell an end to the story – believe a key reason for the hold-up after the end of Ariel Sharon's premiership was to press him into also ratifying a separate "non-ideological" land transaction with the Church at Beit Shemesh, in which the attorney Uri Messer represented the purchasers. Mr Messer has denied trying to hold up Theophilus's recognition. (To add an entirely separate complication to the saga of Greek Orthodox land transactions, two Israeli businessmen Yaacov Rabinowitz and David Morgenstern, were yesterday convicted of defrauding the Church of $20m by making bogus land deals seven years ago).

But it is Jaffa Gate which is of real international interest. The idea that elements within the Israeli government may have previously supported the settlers' cause – something which Danny Seidemann, an Israeli lawyer who has long contested Jewish settlement in Arab parts of Jerusalem has "no doubt" is the case – was arguably especially sensitive in the run-up to the upcoming Annapolis Middle East summit.

While in any peace deal Jews would require what Mr Seidemann calls "an iron-clad guarantee" to use the route from the Jaffa Gate through the Armenian Quarter to the Jewish Quarter with freedom and safety, the strategic purpose may be to create a new Jewish "contiguity" between the Jaffa Gate and the Jewish Quarter which would disturb the delicate – but functioning – separation of Arab and Jewish quarters. Nor will settler designs on Arab buildings in the Old City end with Theophilus's recognition. "If you throw them out of the window they come under the lentil of the door," says Mr Seidemann. "The stake which will go through the heart of the settlers has not been invented."

The patriarch has repeatedly stressed that he is not a politician, and leaves politics to those who are. But he says the patriarchate's extensive landownership, not least in the Christian Arab quarter behind the Imperial, is "why those who have their own interests and want to bring about changes in the natural demography of Jerusalem, the physical demography of Jerusalem, try and do this through the patriarchate". While stressing that the $2m Jaffa Gate transaction could yet wind up in the courts, and that he will always honour properly reached agreements with any party, he adds: "This is a legal matter and it should be dealt with legally. I am the wrong man for certain people because they had other plans in mind and they were not fulfilled." But he also sees the Church as having a "moral responsibility to leave the city as it is, and this has always been our policy".

Recording that the city's historic role has been as a "meeting place for Jews, Christians and Muslims" he says that part of the "beauty and greatness of Jerusalem" is that "it should be an example of co-existence, and an example of religious and cultural diversity". It seems that Theophilus has won a crucial battle, but not yet, perhaps, the war.