* Says two sides need to help each other succeed (Rewrites first paragraph with settlement issue; addsbackground, new quotes)

By Andrew Quinn

WASHINGTON (Reuters) - U.S. President Barack Obamasaid Friday he told Israeli Prime Minister BenjaminNetanyahu it would "make sense" to extend a freeze on newJewish settlement construction in the West Bank while peacetalks with Palestinians are moving forward.

Acknowledging that the settlements are "a major bone ofcontention", Obama said he believed that it would be sensible,if politically difficult, for Netanyahu to extend Israel'sself-imposed moratorium in new settlement building when itexpires on Sept. 26.

"It makes sense to extend that moratorium so long as thetalks are moving in a constructive way," Obama said at a WhiteHouse news conference.

"Ultimately the way to solve these problems is for the twosides to agree what's going to be Israel, what's going to bethe state of Palestine. And if you can get that agreement, thenyou can start constructing anything that the people of Israelsee fit in undisputed areas," Obama said.

The comment marked Obama's first direct mention of thesettlement moratorium, which many analysts say threatens toderail the new Mideast peace negotiations almost before they'vebegun.

Netanyahu met Palestinian President Mahmoud Abbas inWashington last week, ending a 20-month hiatus on direct peacetalks that Obama hopes will yield a deal within a year for anindependent Palestinian state alongside Israel.

Despite widespread skepticism over the chances for success,the two leaders agreed to meet again every two weeks. The nextsession will be in Egypt on Sept. 14, with U.S. Secretary ofState Hillary Clinton also attending.

But Israel's decision on the moratorium looms. Abbas hassaid he may drop out of the talks if the freeze is notextended, but Netanyahu -- whose governing coalition isdominated by pro-settler parties -- has appeared reluctant totake that step.

Obama said Friday he saw "enormous hurdles" ahead in thenegotiations, but said it was a risk worth taking and theUnited States would remain engaged even if talks break down.

"The two parties need each other. That doesn't mean it'sgoing to work. Ultimately it's going to be up to them," Obamasaid.

"I remain hopeful but this is going to be tough," Obamasaid. "It's a risk worth taking because the alternative is astatus quo that is unsustainable. And so if these talks breakdown, we're going to keep on trying."

TERRITORIAL INTEGRITY

Abbas has repeatedly called for a total freeze on theexpansion of settlements Israel has built on land it capturedin the 1967 war, arguing that the creeping developmentthreatens the integrity of a future Palestinian state.

Netanyahu declined to impose a blanket freeze, but didagree to a 10-month halt to new housing starts in West Banksettlements -- a step Obama said Friday had led tosignificant reduction in new construction.

Obama said he had urged Abbas to take steps to demonstratehis sincerity in taking part in the peace process, saying thiscould help Netanyahu take the politically difficult decision toextend the moratorium.

The key U.S. objective now, Obama said, was "to make surethat President Abbas and Prime Minister Netanyahu startthinking about how can they help the other succeed, as opposedto how do they figure out a way for the other to fail."

Obama repeated that the United States remained committed tofinding a final deal, which he said could "change the strategiclandscape in the Middle East" and help U.S. efforts to pressureIran over its nuclear program.

"This is something in our interests. We're not just doingthis to feel good. We're doing it because it will help secureAmerica as well. (Reporting by Andrew Quinn; Editing by Tim Dobbyn)