JERUSALEM (Reuters) - Israel and the European Union will drift apart if they cannot compromise on new EU guidelines covering Jewish settlement on occupied land that could damage research and trade ties, Israeli's deputy foreign minister said.
The two sides must overcome the dispute - focused on territory that Palestinians want for a state - before the end of November, when a multi-million dollar EU research program called Horizon 2020 is due to be finalized.
If there is no deal, Israel risks missing out on generous funding for its scientists. By the same token, Europe will lose Israeli-know how, Deputy Foreign Minister Ze'ev Elkin said.
"If we fail to resolve this problem, the future direction will be a kind of separation between Israel and the European Union," Elkin told Reuters in an interview.
"We are the start-up nation. It would be a big mistake for Europe to lose its relations with Israel," he said.
A senior EU official visited Israel this week, promising that the 28-nation bloc wanted to work closely with Israel and its burgeoning hi-tech economy, but all efforts so far to bridge their differences have failed.
Despite Israel's intimate diplomatic and military ties with the United States, its biggest economic partner by far is the European Union, which accounted for almost third of all exports and imports into the Jewish state last month.
Despite deep historical links, relations between Israel and Europe have grown more bumpy in recent years, with the EU increasingly vocal in its criticism of Jewish settlements, saying they imperil the chances of peace with the Palestinians.
Matters came to a head in July, when the EU's Executive Commission announced it would bar financial assistance to any Israeli organization operating in the West Bank from 2014.
The move finally put some teeth into EU opposition to settlements built on territory Israel seized in a 1967 war and which are now home to more than 500,000 Israelis. Palestinians want the land for part of a future independent state.
When the guidelines were unveiled, Israel furiously accused EU bureaucrats of lying about the scope of the measures. Surprised by the angry response, EU officials said Israel had failed to grasp European frustration over settlement expansion.
"This had been in the pipeline for months. The problem was that the Israelis did not originally understand the (bureaucratic) language, so felt exposed," said a senior European diplomat in Jerusalem, who declined to be named.
Israel has since toned down the criticism, but Elkin said the EU move was aimed at imposing new borders on Israel via trade sanctions rather than through on-going negotiations with the Palestinians. He also said that it meant the Europeans could dictate where Israeli money went in any joint ventures.
"As it stands, we cannot sign Horizon 2020. It would force us to discriminate (against) our own institutions," said the pro-settler Elkin, who, unlike Prime Minister Benjamin Netanyahu, does not believe the Palestinians should have their own state.
Although it carries much less weight in the region than the United States, Europe has nonetheless managed to precipitate important diplomatic moves that were later followed by others.
In 1980, it recognized the Palestine Liberation Organization (PLO) when both Washington and Israel still considered it to be a terrorist group. It also pushed for an independent Palestine before the United States adopted the same position.
The EU has said it will not change the new guidelines, but is looking at ways for a flexible implementation of the rules.
"No progress has yet been made on reaching a common understanding," said an official involved in the talks.
The European Commissioner for Industry, Antonio Tajani, brought a delegation of more than 60 EU businessmen to Israel this week and sought to play down the dispute.
"There are problems, of course. But the message is, we want to work with Israel," he told Reuters in Tel Aviv.
Senior EU diplomat Pierre Vimont is due to visit Israel before the end of the month to discuss the impasse.
"The Europeans tell us not to worry, but of course we worry, we are Jewish," said an Israeli official involved in the discussions. "We want clear commitments on how this will be implemented, and we want it in writing."
Additional reporting by Adrian Croft, Justyna Pawlak and Luke Baker in Brussels, editing by Mark Heinrich