I think the best hope for the moment is for the negotiations that have been going on between Abbas and Olmert to set up a Palestinian state in the West Bank succeed. They have been closer to success than most people in North America can believe ... and I hope that Olmert's imminent loss of the prime ministership does not torpedo the discussions.
The Palestinians of the West Bank are really quite secular, much as most of the Jews of Israel are secular. They want peace, economic development, security.
If a Palestinian state is established on the West Bank, then the Palestinians of Gaza, currently under the boot of Hamas, may see the merits of a more realistic approach to Israel, which is not going anywhere. If they don't, they will sink even further into poverty and marginalization.
As for Jerusalem, it's not as vexed a question, some believe, as we've been given to believe. The Arabs and the Israelis are still living in quite discrete sections, although there are some very small points of Jewish development in East Jerusalem. Many observers think that a division of the city is quite achievable.
The problem is that the discussions on setting up a Palestinian state seem to have been based largely on the good rapport that Abbas and Olmert have established with each other. Olmert is due to step down once his governing party, Kadima, elects a new leader in September. Whether another leader can continue on Olmert's course is the great question.