Rival Palestinian groups Hamas and Fatah reached an "understanding" in Cairo on Wednesday to set up a transitional unity government and hold elections, Hamas and Fatah sources said.

Hamas leader Izzat Ar-Rishiq confirmed the initial agreement. Ar-Rishiq said Cairo will call all factions to sign the final reconciliation within the week with the presence of Mahmoud Abbas and Khalid Mash'al.

Egypt's official MENA news agency said the factions "reached a complete understanding after talks on all the points, including the formation of a transitional government with a specific mandate and setting a date for elections."

Egypt will now call a meeting of all Palestinian factions to sign a reconciliation agreement in Cairo, MENA added.

Fatah delegation chief Azzam Al-Ahmad confirmed the report and said the two sides had agreed to set up a "government of independents."

"This government will be tasked with preparing for presidential and legislative elections within a year," Al-Ahmad said in a phone call in Ramallah.

Israel's Prime Minister Benjamin Netanyahu reacted immediately, demanding that President Mahmoud Abbas "choose between peace with Israel or peace with Hamas."

Netanyahu said such an agreement paved the way for Hamas to take control of the West Bank too, where Abbas and the Palestinian Authority have their headquarters.

"The Palestinian Authority must choose between peace with Israel or peace with Hamas. There cannot be peace with both because Hamas strives to destroy the state of Israel and says so openly," Netanyahu said.

"I think that the very idea of reconciliation shows the weakness of the Palestinian Authority and creates the prospect that Hamas could retake control of Judea and Samaria just like it took control of the Gaza Strip," he said, referring to the West Bank.

Nabil Abu Rudeina, a spokesman for Abbas, dismissed these remarks.

"In reaction to Netanyahu's remarks we say that Palestinian reconciliation and the agreement reached today in Cairo is an internal Palestinian affair," Nabil Abu Rudeina said.

Netanyahu, he said, "must choose between peace and settlements."

The United States, meanwhile, said it supported Palestinian reconciliation on terms "which promote the cause of peace." Hamas, however, "is a terrorist organization,” said spokesman Tommy Vietor.

"To play a constructive role in achieving peace, any Palestinian government must accept the Quartet principles and renounce violence, abide by past agreements, and recognize Israel’s right to exist," he said.

Hamas and Fatah were on the verge of agreeing to the same deal in October 2009 but the Islamist movement backed out, protesting the terms had been revised without its consent.

Wednesday's deal was brokered in Cairo where the factions met with Egypt's new spy chief Murad Muwafi, whose predecessor Omar Suleiman tried unsuccessfully to bridge a split that has left Gaza and the West Bank ruled by rival administrations.

The Hamas delegation included senior members from Gaza as well as its Damascus-based deputy leader, Mussa Abu Marzuk.

On March 16, the president said he was ready to visit Gaza for talks with Hamas leaders to form a new government in order to pave the way for an agreement with Hamas on the formation of non-partisan cabinet lineup ahead of elections.

"I am ready to go to Gaza tomorrow to end the division and form a government of independent national figures to start preparing for presidential, legislative and National Council elections within six months," he said.

And earlier this month, Abbas told AFP that Iran had ordered Hamas not to reconcile with its long-time secular foe, prompting an angry response from the Islamist movement which said he was responsible for blocking a unity deal.

"Until now Hamas refuses to say 'yes' or 'no' to the initiative" -- to put an end to divisions, form a new government and prepare for elections, he said, adding: "Now the ball is in their court."

Cairo has long tried to broker a deal bring the two warring factions, and in October 2009 brokered a deal which would have led to a transitional government followed by elections. Fatah signed the deal, but Hamas stalled and the agreement was never implemented.

Tensions between the two movements date back to the start of limited Palestinian self-rule in the early-1990s when Fatah strongmen cracked down on Islamist activists.

They worsened in January 2006, when in a surprise general election rout, Hamas beat the previously dominant Fatah to grab more than half the seats in parliament.

Hamas expelled Fatah from Gaza after a week of deadly clashes in June 2007, cleaving the occupied Palestinian territories into rival hostile camps.

Since then, Gaza has been effectively cut off from the West Bank, which is under the control of Fatah, and repeated attempts at reconciliation have led nowhere.

The disunity of the Palestinians has prevented them from taking a common stance in peace talks with Israel, which are now off the table.