UNITED NATIONS, Sept 27 (Reuters) - Palestinian President Mahmoud Abbas said on Thursday he would seek to have the Palestinians' U.N. status upgraded to a sovereign country and cautioned that Israeli settlement expansion meant time was running out for a two-state solution.

"Despite all the complexities of the prevailing reality and all the frustrations that abound, we say before the international community there is still a chance - maybe the last - to save the two-state solution and to salvage peace," Abbas told the U.N. General Assembly.

But he warned the 193-nation assembly that Israel was "promising the Palestinian people a new catastrophe" if it continued with its current Jewish settlement policies in the occupied West Bank.

The so-called two-state solution involves the creation of a state of Palestine to exist peacefully alongside Israel.

After failing last year to win recognition of full statehood for the Palestinians at the United Nations, Abbas is looking for a less-ambitious status upgrade at the world body that would make it a "non-member state" like the Vatican.

The Palestinians' current U.S. status is that of an "observer entity." If Abbas gets his way, that would change to "observer state."

Upgraded status for a Palestinian state could be uncomfortable for Israel. Being registered as a state rather than an entity would mean the Palestinians could join bodies such as the International Criminal Court (ICC) and file a raft of complaints against Israel for its continued occupation.

Abbas said that seeking an upgrade of Palestinian membership was not aimed at harming Israel.

"In our endeavor, we do not seek to delegitimize an existing state - that is Israel - but to assert the state that must be realized - that is Palestine," he said.

This time around, Abbas looks certain to get his way, U.N. diplomats say, but the resolution he plans will not bring true independence any nearer. It will also anger the United States as well as Israel, which is likely to retaliate with painful economic countermeasures.

"LIBELOUS SPEECHES"

In 2011, when Abbas bid for full U.N. statehood, there was excitement in the West Bank.

Predictably, the request wilted in the face of fierce U.S. opposition.

U.N. Secretary-General Ban Ki-moon said on Tuesday that the two-state solution was the only sustainable option for peace. But he said the continued growth of Israeli settlements meant that "the door may be closing, for good."

Abbas said that for the past year Israel, "the occupying power, has persisted with its settlement campaign, focusing on Jerusalem and its environs."

"It is a campaign of ethnic cleansing against the Palestinian people via the demolition of their homes and prevention of their construction, the revocation of residency rights, the denial of basic services," he said.

Israeli Prime Minister Benjamin Netanyahu spoke shortly after Abbas and reiterated his call for direct talks. He also made clear he was not pleased with the Palestinian address.

"We won't solve our conflict with libelous speeches at the U.N.," he said. "That's not the way to solve it. We won't solve our conflict with unilateral declarations of statehood."

"We have to sit together, negotiate together, and reach a mutual compromise, in which a demilitarized Palestinian state recognizes the one and only Jewish State," Netanyahu said in a speech that was mostly focused on Iran's nuclear program.

There have been no direct Palestinian talks with Israel since 2010, when the Palestinians refused to resume negotiations unless the Israeli government suspended settlement building in the West Bank and East Jerusalem.

Rob Danin, an analyst at the Council on Foreign Relations think tank, said Abbas' focus on the Israeli-Palestinian conflict and Netanyahu's on Iran illustrated the difficulty of getting the two sides back into serious peace talks.

"Whoever emerges as U.S. president on November 6 will be forced to find a way to reconcile these competing Israeli and Palestinian priorities," he said. "Otherwise, Abbas and Netanyahu are each likely to pursue paths that conflict with current U.S. approaches."

The United States has also called for renewed direct talks.