Talks on transferring further control of the West Bank to the Palestinians have broken down.
Palestinians want Israel out of Ramallah
Officials on both sides said disagreement centred on which two towns should next be vacated by Israeli troops.
The dispute clouded the first high-level talks since the Israeli and Palestinian prime ministers paid separate visits to Washington over the past week to discuss the US-backed roadmap peace plan.
Meanwhile, Palestinians have reacted angrily after the Israeli Government invited bids to build new homes in a Jewish settlement in the Gaza Strip.
Palestinians say such a move violates the roadmap, which calls for a freeze on settlement activity.
The tender offers rights to build 22 new housing units in the settlement of Neveh Dekalim
Nabil Abu Rudeineh, an aide to Palestinian leader Yasser Arafat, called the move "a very dangerous step".
ROADMAP MAIN POINTS
Phase 1 (to May 2003): End to Palestinian violence; Palestinian political reform; Israeli withdrawal and freeze on settlement expansion; Palestinian elections
Phase 2: (June-Dec 2003) Creation of an independent Palestinian state; international conference and international monitoring of compliance with roadmap
Phase 3 (2004-2005): Second international conference; permanent status agreement and end of conflict; agreement on final borders, Jerusalem, refugees and settlements; Arab states to agree to peace deals with Israel
In talks in Jerusalem on Wednesday night, Palestinian security chief Mohammed Dahlan sought Israel's withdrawal from Ramallah, where Mr Arafat has been marooned for more than a year by Israeli forces.
But Israeli Defence Minister Shaul Mofaz would only agree to withdraw from Jericho and Qalqilya.
However, the Israeli daily Haaretz suggested that a compromise might be reached such as Israel agreeing to transferring a third city instead of Ramallah, viewed as too politically sensitive at this time.
Jericho has been largely bypassed by nearly three years of violence and its handover would be seen as a formality.
Except for a brief invasion in September 2001, Israeli forces have not entered the town, and Palestinian police have been in control there.
Qalqilya is at the edge of the West Bank, just a few kilometres from the Israeli city of Kfar Saba.
In Qalqilya, hundreds of demonstrators have protested against a controversial security fence being built by Israel, and called for its removal.
Palestinians and foreign activists marched through the town, chanting: "Brick by brick, wall by wall, the occupation has to fall".
Some protesters hurled balloons filled with red, black, white and green paint - the colours of the Palestinian flag - at the wall, as a group of soldiers looked on.
The Israeli Government says the barrier, planned to stretch 600 kilometres (370 miles), is necessary to impede suicide bombers crossing from the West Bank into Israel.
Palestinians say it is an attempt to grab land and destroy their dreams of statehood.