JERUSALEM (Reuters) -- Named for the crash site of an airforce plane shot down during the Six Day War in 1967, Givat HaMatos may yet prove the place where Palestinian hopes of a creating a capital in Jerusalem also plunge to earth.

'Airplane Hill' lies on the southern fringes of Jerusalem's city limits -- rock-strewn land dotted with shabby, prefabricated bungalows and the occasional pine tree.

Once a tranquil backwater, the area has become the focus of hectic activity in the last six months, with Israeli authorities releasing plans for 2,610 housing units and 1,110 hotel rooms.

With the approval process going more quickly than expected, building could start later this year, creating the first new Israeli settlement in 15 years among the sprawl of a modern Jerusalem that is spread out over many hills.

If that happens, it would effectively cut off the city's Palestinian neighborhoods from Bethlehem in the occupied West Bank, imperiling the Palestinians' prospects for establishing a coherent capital and with it their goal of an independent state.

"There is only so much territorial abuse this tortured land can take before we kill the political options of saving the two- state solution," said Daniel Seidemann, an Israeli attorney who monitors urban developments he thinks affect chances for peace.

"What is happening at Givat HaMatos is a game changer," he said, his finger tapping a map of the area for added emphasis. "Events are careering out of control."

Of all the obstacles blocking the way to peace between the Palestinians and Israelis, the status of Jerusalem is arguably the most intractable.

"It's the most difficult symbolic issue for the peace process. It's an emotional issue," Israeli Prime Benjamin Netanyahu told Reuters earlier this month.

For Israelis, all of the city, including East Jerusalem and its West Bank suburbs captured in 1967, is their "eternal and indivisible" capital, the home the Jews dreamed of through 2,000 years of exile, and the site of their revered Western Wall.

For Palestinians, there can be no peace until Israel returns their control over East Jerusalem, a symbol of their national struggle and home to Islam's third holiest site, al-Aqsa mosque and the glittering Dome of the Rock.

In the absence of a deal, or even meaningful negotiations, Israel has been busy developing the holy city, building impressive, stone-clad neighborhoods across the occupied land in defiance of constant international criticism.

Precious land

A series of recent interviews with Israelis and Palestinians suggests that the development is at a tipping point.

Plans for Givat HaMatos are not taking place in a vacuum.

Israeli officials are also pushing to expand the nearby settlements of Gilo and Har Homa, thereby building a broad, concrete crescent just north of the hilltop town of Bethlehem.

Some 35 percent of Palestinian economic activity is centered on a line that stretches from Bethlehem through East Jerusalem and on to Ramallah, the West Bank's administrative center, north of Jerusalem. Critics say the southern settlements will snap this link.

"It is like putting a ribbon around a finger and pulling tighter and tighter until all the blood is cut off," said Ashraf Khatib, a Palestinian activist from East Jerusalem.

"But it is not just in the south. The Israelis are creating facts on the ground across the eastern city," he added.

A proud exponent of that policy is Aryeh King, the founder of the Israeli Land Fund whose stated mission is to "reclaim the land of Israel for the people of Israel."

In April, he secured the eviction of a Palestinian family from a home in the Palestinian neighborhood of Beit Hanina after a court ruled that the place had been legally bought by a Jew. He immediately moved half a dozen young supporters into the house and promised further evictions in the months ahead.

"We are locating property in all of East Jerusalem. In Jerusalem, every piece of land is important. All the plots put together can change the reality," said King, standing in the backyard of the low-rise building he had just taken over.

"The reality we don't want to see happen is one that we think would lead to catastrophe -- the division of the city."

Jews, from Biblical kings such as David and Solomon to present day Israelis, see Jerusalem as the home of their religion and as a national capital fit for their people.

Most Israelis dismiss accusations their presence in East Jerusalem is illegal and bridle at the term "settlement" to describe what they refer to as Jewish neighborhoods.

Population growth

As British imperial forces left Palestine in 1948, 60 percent of Jerusalem's population was Jewish. The United Nations had planned to put the city under international control, but war intervened and when a truce ended it, Jordan held the eastern sector, including the walled Old City with its sacred sites.

Israel controlled West Jerusalem.

Following the 1967 war, Israel swept away the armistice boundary, or Green Line, and more than doubled the city limits. In 1980, parliament passed a law declaring united Jerusalem as the national capital, a move never recognized internationally.

Palestinians say the new masters have striven to alter the demographics, limiting land available to develop in Palestinian neighborhoods, imposing residency rules that push Palestinians out and demolishing more than 2,000 of their homes in East Jerusalem.

This has had little impact on population ratios, even as the number of inhabitants has soared from 263,000 in 1967 to around 800,000 today. Indeed the Palestinian ratio is climbing, with secular Israelis reluctant to settle in a city known for tensions and as home to growing numbers of religiously observant Jews.

According to the Jerusalem Institute for Israel Studies, 36 percent of inhabitants were Palestinian in 2009 against 28 percent in 1980. City officials say the figure will hit 40 percent by 2020. By contrast, 20 percent of Israel's total population are Palestinians.

"Jerusalem is not a Jewish city, not an Israeli city, but a bi-national city. It is not a united city. It is divided in more ways than you could care to imagine," said Seidemann, who is the go-to person for diplomats seeking information on town planning.

The divisions are often invisible to the naked eye. Outsiders rarely notice when they cross from west to east, and are surprised if Jewish taxi drivers refuse to take them to hotels in Palestinian areas because they fear being pelted with stones.

Likewise, both visitors and residents often express surprise when told that leafy districts of solid, modern homes are the very settlements which are so regularly denounced abroad.

"This place isn't a settlement," said Ofer Dror, a 36-year-old technician and resident of Har Homa, a terraced suburb of neat, white-stone apartments housing 13,000 Israelis that overlooks the Biblical town of Bethlehem.

"If we were behind some fence or a separation line then I might think that," he added, clearly surprised by the concept.

Winners and losers

Ironically, just a hundred meters from Har Homa's outer ring of houses, lives a Palestinian shepherd stranded by a fence.

Saed al-Zawahri lost a third of his land as the settlement spread this past decade. He grazes his small flock of sheep over his remaining three acres, cut off from Bethlehem, which lies tantalizingly close behind coils of barbed wire.

Israel has sealed much of the West Bank behind walls and fences in what Palestinians say is a land grab. Israel's separation wall is not built on the Green Line but rather runs deep inside the West Bank.

This has ensnared Zawahri in a bureaucratic mess.

Denied Jerusalem residency, he says he is only allowed to travel to Bethlehem but is not entitled to register a car with Israeli license plates to drive on the Israelis-only roads he would need to get him there. Likewise, he says he does not have the right to shop in the adjacent Har Homa and must call in special deliveries from Palestinian stores.

"They plan a thousand years ahead," said the 74-year-old shepherd. "They plan to get rid of us."

Asked if anything could stop the Israeli expansion, he smiled wryly. "Only God. All the Arab armies already tried and failed," he said, referring to the wars of 1948, 1967 and 1973, when combined Arab forces tried but failed to defeat Israel.

However, recent events in Jerusalem suggest that the United States could influence policy-making if it wanted to.

A review of city planning activity shows that between March 9 and Nov. 1 in 2010 there was a de facto halt on settlement work in the city and again from Jan. 3, 2012 to early April.

The first period coincided with intense US lobbying for a freeze to entice the Palestinian leadership into peace talks -- negotiations that swiftly broke down when Netanyahu rejected Palestinian demands to maintain the halt.

There is no clear explanation for the second period of inactivity, although some diplomats have suggested Netanyahu applied the brake to avoid rows with Washington as he sought to gain US support for a tough stance on Iran's nuclear strategy.

"Israel failed to get the green light from America to attack Iran. Shortly afterward the building plans for Jerusalem accelerated. Who knows if these two facts are connected?" said a senior Western diplomat in Israel who declined to be named.

Israeli officials said the apparent freeze was coincidental.

Municipal leaders complain openly about the outside pressure that is brought to bear as they seek to run one of the world's iconic cities, administering garbage collection, school buses and restaurant permits, while welcoming in the tourist hordes.

"Everything stood still for quite a few months but from the point of view of the city's various populations it was tragic," says Deputy Mayor Naomi Tsur, adding that the order in 2010 to stop work had come directly from Netanyahu.

"This is a living city. People have to live somewhere, send their children to schools," she said. "When we are left to ourselves we know how to do it, but we are not left to ourselves."

With peace talks blocked and world attention fixed on myriad other crises, the floodgates have lifted and the city authorities seem to have a free hand to do what they want.

Out in Givat HaMatos, the bulldozers could swing into action by the autumn, when the summer heat starts to fade.

"The geography and demographics will then be so Balkanised that the two-state solution will be gone," said Seidemann.

"All the analysts we have met in the intelligence community in Europe and the United States, including the White House, see it and know it is coming."