JERUSALEM, May 21 (AP)--As violence simmered in the West Bank and Gaza Monday, Israelis and Palestinians welcomed the report of a commission on stopping eight months of violence--but there was little movement on the thorny question of construction in Jewish settlements.

The commission led by former U.S. Sen. George Mitchell included a freeze on all such construction among its recommendations, and the Palestinians said this is a precondition to a truce. Israel, which wants to build in existing settlements to account for ``natural growth,'' insisted violence must stop first.

The violence continued on the ground, meanwhile.

Two Palestinians were killed in a clash near Gaza City after Israeli helicopters rocketed a building next to a sprawling refugee camp. Israel said the building was a mortar shell factory, but Palestinians said spare parts for cars were made there.

Israel said the two were shot while planting explosives nearby. Palestinian security officials first said they were farmers en route to their field; however, wall graffiti signed by Palestinian leader Yasser Arafat's Fatah movement said they were killed in a firefight.

Palestinians also fired two mortar shells Monday toward the Jewish settlement of Netzer Hazani in Gaza. No one was hurt. In response, the army briefly crossed into Palestinian-controlled area nearby and leveled a police post.

Also Monday, an Israeli man was wounded when Palestinians opened fire on the Jewish neighborhood of Gilo in a disputed part of Jerusalem. Israeli media reports said he lost an eye. Police said three children were lightly injured as well.

Earlier Monday, U.S. ambassador Martin Indyk criticized Israel's military moves, especially Sunday's tank shelling of the home of a top West Bank security chief, Jibril Rajoub, considered among the more moderate Palestinian figures.

``Those who would stop the violence, the Palestinian police ... are being hit, bombed, shelled (and) killed by the Israeli Defense Forces,'' said Indyk. ``Maybe the strategy is to encourage them to act against their own people, but I don't imagine that there is an example in history where such strategy succeeded.''

In New York, Mitchell presented the report of the international commission he headed to investigate the violence and recommend ways to stop it. He called on the Palestinians to recognize that terrorism is unacceptable, arrest terrorists, find the sources of anti-Israel incitement and stop it.

He said Israel must use non-lethal methods to disperse demonstrations, release tax money collected for the Palestinians and freeze all construction in Jewish settlements in the West Bank and Gaza Strip.

Palestinian negotiator Saeb Erekat said the settlement issue was a key to progress, and Arafat's Palestinian Authority released a statement welcoming the recommendations, ``above all the stopping of settlement activities and an end to the violence against the Palestinian people.''

Prime Minister Ariel Sharon said he had not seen the final version, but said ``the formula of the Mitchell report is acceptable to us.''

Israeli officials complained about the cease-fire for settlement freeze concept. ``The linkage is the problem, because that means you bring negotiations under fire through the back door,'' said Raanan Gissin, spokesman for Israeli prime Minister Ariel Sharon. Sharon has ruled out peace talks until all violence stops.

U.S. Secretary of State Colin Powell, who endorsed the Mitchell report, said the cessation of violence is not dependent on stopping construction in the settlements, and Gissin said that was the most significant point.

Justice Minister Meir Sheetrit, a member of Sharon's Likud party, said a freeze could be discussed later. ``First violence should be stopped, then we are willing to negotiate anything,'' Sheetrit told The Associated Press.

Israel has rejected a total freeze, saying that the needs of the settlement population - about 200,000 Israelis in 144 settlements - must be taken into account.

A survey published Monday in the Yediot Ahronot daily indicated that 61 percent of Israelis support a settlement freeze in exchange for a cease-fire. Thirty-four percent were opposed, said the survey, which questioned 504 Israelis and reported a margin of error of 4.5 percent.

Also Monday, Israel held its annual celebration of Jerusalem Day, marking the unification of the city under Israeli control in the 1967 Mideast war, when Israeli soldiers captured the Arab sections and the Old City, with sites holy to Muslims, Christians and Jews.

In aborted peace talks, former premier Ehud Barak had offered to share the disputed part of the city. The Palestinians rejected that as insufficient.

Addressing a Jerusalem day gathering, Sharon said he would not offer the Palestinians any of Jerusalem. Sharon said Jerusalem ``is the heart of the Jewish nation and at its center, united and indivisible, forever and ever.''

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