My first warning on this post is I really have no idea what the answer is. But there are a few points worth noting, that bring up a few questions.
1) The Hamas Coup. Still acting like a terror cell as much as a political party, Hamas' violent purging of Fatah in the Gaza Strip (as soon as it had a big enough advantage in firepower) has shown complete disregard for the creation of a stable independent state... but this is not surprising. The party officially still insists on the dissolution of Israel before peace is possible. How do you fix a region run like this? Not sure.
2) Geography. Making a country that is split by its greatest security threat (Gaza Strip and West Bank split by Israel) seems stupid, and it is. Germany hated Poland long before 1939 because of the Danzig Corridor, and an independent Palestine would have serious trouble maintaining administration, security, and trade unless Israel was willing to allow free flow, through Israel, between the two regions. Unfortunately, because of 50 years of constant terror and military threats from the Palestinian regions, such free flow is almost certainly politically infeasible (and probably not actually a great idea).
3) The Security Dilemma. Neither side (Israel or Palestine) is willing to promise peace without security assurances, and neither side can give these assurances, largely because of Hamas and other terror organizations. Israel could try to be the "grown-up," given its military strength, give Palestine its political and security concessions, wait for peace, and then get its own concessions later, but while Olmert and Abbas might be willing to work with this plan, non-state actors in Palestine (particularly Hamas-type fanatics) are impossible for the Palestinian state to effectively control, and they would likely continue to use terror to increase their political gains, as they have done in the past. Therefore, Abbas cannot possibly make security promises to Israel, and therefore, Israel cannot (in its own interest) let Palestine yet have a free state. Again, I do not know how to fix this dilemma.
4) The Arab States' lack of help. Well, some are helping. Egypt is trying, but Gazan refugees are starting to pour into Egypt, and the Egyptian PM is literally threatening to break legs. Egypt's cooperation with the Israeli blockade is somewhat rare. Iran's Hezobllah militants in Lebanon seem to be vying for another war with Israel, and Syria has refused to help make peace in the Palestine issue until gives back the Golan Heights--a mountain range through which Syria invaded Israel multiple times.
5) Israel's Inconsistency. Israel has been inconsistent about its responses against terror attacks by Gazan militants. Israel forced its settlers from Gaza (which was, in general, the right thing to do) amid uncharacteristically high terror attacks, which may have made Hamas think such terror attacks would win political victories... even now, Israel's military responses range from lackluster to extreme, and Palestinian civilians cannot be clear on what kind of behavior will bring them peace and prosperity. Palestine is much like a colony of Israel, and Israel will have to take care of the Palestinian people or let them be free... doing neither will only create more resentment.
But we are certainly stuck. Israel and Palestine both need promises of security before political progress can be made, and this makes one think "UN Intervention," but that's unlikely to happen anytime soon (and we see it failed rather miserably in the 2006 Israeli-Lebanon war).
I would love comments from readers on creative peace-making ideas.