This of course again begs the strategic question of why the state of Israel is encouraging people to settle on land that it ostensibly doesn't want to administer and is planning on turning over to some other (perhaps not-yet-existant) state. This leads me to believe that, in fact, the Israeli goal is to hang on to some of the territory currently occupied after a seperation agreement is realized. I don't think such a goal is imorral, although, again, I have to question its practicality.
This BBC story from January, 2001, shows the farthest the peace process got. While I was aware of it at the time, I was not completely cognizant of the status of the Occupied Territories, so I did not have much of an opinion base to work with. Basically, the last offer on the table was that Israel would get "the Jewish quarter" of Jerusalem (unclear if that's a metaphorical quarter or a literal one). Apparently the Jewish quarter is on the wrong side from Israel, so there would be a corridor back to Israel, also owned by Israel, which would unfortunately chop the Palestinian sections into two "islands" that were not connected. The Palestinians would get the Temple Mount, which is the most significant religious site. Israel would give up 90% of the West Bank and all of the Gaza strip. However, the West Bank would end up in some ridiculous gerrymandered form which would make the administration of a Palestinian state difficult at best (even if it weren't already split into two pieces). Finally, the 3.1 - 3.7 million Palestinian "refugees" would be officially denied any right of return, which was a bitter pill for the Palestinian Authority (and its Arab friends, who don't particularly want the Palestinians, either). Personally speaking, I think a reasonable counter-offer from the PA would have been to suggest an alternative partitioning of Jerusalem in order to unite their halves, and some middle ground the gerrymandering of the West Bank, perhaps giving the Israelis some other contiguous land in the West Bank in return for the random parcels it had, now. Instead, the Palestenians walked away from the negotiating table; they seem to see increased offers as weakness and felt they could get more with terrorism.
My opinion on Jerusalem is that it really doesn't matter one way or the other; to me, it's just another piece of land. I realize neither side agrees with me, but I can't help but get angry at both sides if a single innocent on either side is killed over such a stupid thing.
Finally, on the Palestinian "refugee" problem, I think it is very important to realize where this problem came from. In 1948, when Israel declared independence, it was along UN-mandated lines, much like what Israel is currently suggesting happen in the West Bank. The two states were split along demographic lines, so that largey Jewish areas, even if they were surrounded by Arabic ones, became part of Israel. Immediately after declaring independence, Israel was invaded by all of its Arab neighbors (and underwent rebellion by the Arabs who lived inside Israel). Israel was almost wiped out in this, but it fought back and pushed out to basically the current borders of Israel, minus the West Bank and Gaza Strip. In that defensive war, something like 750,000 Arabs were displaced; refugees. Their original homes were in Israel, but, because they either did not wish to live under an Israeli state, or because they were fleeing the fighting, they left. According to the Palestinian Refugee Research Net, about 1/3 of these went to Gaza, about 1/3 went to the West Bank, and the rest went to Jordan, Syria, Lebanon or someplace else entirely.
Subsequently, in the 1967 war, when Israel took the West Bank and Gaza, about 120,000 of those original West Bank and Gaza refugees fled again, followed by another 180,000 new refugees, to Jordan, Syria, Egypt and other countries.
As of 1995, there were about a million refugees in camps in Jordan, the West Bank, Gaza, Lebanon and Syria. These camps are administered by the UN. Outside the camps there were just over two million others in those same places.
I do not believe that these refugees (the vast majority of whom were born outside of Israel) have any moral or legal right of return, any more than the Jews displaced from Europe just a decade earlier have a right of return (much less their children and grandchildren). From what I can tell, most of these refugees fled of their own accord, planning on returning once Israel was crushed. Frankly, I question whether most of them would want to live in an Israel whose population was mostly Jewish.
I think an equitable solution would be to, once a Palestinian state is established, end these camps and have some resettlement program within Palestine, funded either by the Israel or the international community (or some combination of both).
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