"It would be dangerous and a mistake to remove Arafat from the political arena because in our view that would lead to the radicalisation of Palestinian society," Mr Putin said during a news conference in Moscow.
At the same time, he urged the Palestinian leadership to do "everything in its power to stop the activities of terrorists in its region".
The BBC's Caroline Wyatt says Mr Putin's open session with about 700 Russian and foreign journalists at the Kremlin turned into a marathon as the president talked confidently for more than two hours on a number of issues.
Diplomatic push
Mr Putin's comments came as Israeli forces moved back into the West Bank town of Ramallah, surrounding Mr Arafat's headquarters.
But he said any disputes are best resolved by negotiations.
Moscow - a traditionally close ally with the Arab world - has also sent its Middle East envoy Andrei Vdovin to the region trying to establish direct contacts between Israel and Arab states.
Mr Vdovin is continuing consultations within the group of four - Russia, the United States, the United Nations and the European Union - which hope to hold an international conference on the Middle East.
Baltic enclave
Our correspondent says that Mr Putin also gave a robust defence of his pro-Western stance since the 11 September.
He said that Russia needed good international relations to develop trade and improve its own living standards.
But he described as completely unacceptable plans by the European Union to impose visa requirements on Russians visiting the Baltic enclave of Kaliningrad.
"We will never agree with decisions that would split Russian sovereign territory, and adopting some sort of special status for Kaliningrad would inevitably lead to just that," Mr Putin said.
Kaliningrad is cut off from the rest of Russia by Poland and Lithuania, but Russian citizens are currently allowed to travel there without visas.
The Russian leader also said the conflict in Chechnya should not be blamed entirely on the Chechen people, adding that Moscow had to take the blame for failing to protect the interests of the Chechens.
It was the second news conference of the Russian president to the world's media.
Our correspondent says that, above all, Mr Putin was keen to present himself as a man of the people.
Asked if he felt out of touch at the Kremlin, he said that throughout his years with the KGB, he had lived in a communal apartment and so knew exactly how ordinary Russians felt.