A flare-up of violence in the Palestinian West Bank and a deadlock over Jewish settlements there loom as potential deal-breakers for Obama, who will host Israeli and Palestinian leaders for dinner at the White House in Washington.
Obama brought Prime Minister Benjamin Netanyahu and Palestinian President Mahmoud Abbas together for face-to-face negotiations after months of U.S.-mediated indirect talks. But he faces deep scepticism about his chances of success.
Defence minister Ehud Barak's rare comments about the need to partition Jerusalem, which is at the heart of the conflict, could signal Netanyahu's willingness to divide the holy city in any final peace deal with Palestinians.
Netanyahu has publicly balked at ceding the eastern, Arab part of the city that Israel captured in the 1967 Mideast war.
West Jerusalem and 12 Jewish neighbourhoods that are home to 200,000 (Israeli) residents will be ours, Barak told the Haaretz newspaper.
The Arab neighbourhoods in which close to a quarter million Palestinians live will be theirs, he added, referring to East Jerusalem, which the Palestinians want as capital of a future state in the West Bank and Gaza Strip.
He said a special regime will be in place in the Old City, where al-Aqsa, Islam's third-holiest shrine, abuts the Western Wall, the vestige of Judaism's two ancient temples and today a Jewish prayer plaza.
Barak also said a shooting attack that killed four Israelis in the West Bank on Tuesday would not derail the talks. Militants from the Palestinian group Hamas, which opposes peace with Israel, claimed responsibility.
Palestinian leaders committed to the peace process joined Israel and the United States in condemning the attack, sending a clear message the talks would go ahead after a 20-month hiatus.
Abbas's security forces arrested 150 Hamas members in the West Bank after the attack.
This kind of savage brutality has no place in any country under any circumstances, U.S. Secretary of State Hillary Clinton said in Washington shortly as she met Netanyahu.
Obama will meet separately with Netanyahu and Abbas on Wednesday before hosting them for dinner, the warmup for formal talks on Thursday at the State Department.
The summit marks Obama's riskiest plunge into Middle East diplomacy, not least because he wants the two sides to forge a deal within 12 months. He is staking precious political capital on the peace drive in a U.S. congressional election year.
There is also the danger that failure on this front could set back Obama's faltering attempts at winning over the Muslim world as he seeks solidarity against Iran.
The Hamas attack was a reminder that the Islamist group, which controls the Gaza Strip, remains a threat to peace moves by the moderate Abbas, whose Fatah party governs the West Bank. Hamas threatened more attacks.
The violence could make Netanyahu less likely to accede to Palestinian demands for more control of security in the West Bank. They also want Netanyahu to extend a freeze on Jewish settlement building there.
The 10-month, partial Israeli moratorium on new housing construction in settlements expires on September 26. Abbas has said he will pull out from the talks if the freeze is not extended.
Netanyahu, who heads a government dominated by pro-settler parties, has not given any definitive word on whether he will extend it. Obama's aides have been scrambling for a compromise.
Netanyahu said he would insist in the talks with Abbas that security arrangements in any final peace deal would not expose Israel to attacks like Tuesday's shootings.
We will not let terror decide where Israelis live or the configuration of our final borders. These and other issues will be determined in negotiations for peace that we are conducting, Netanyahu said.
The four Israeli settlers, two men and two women, one pregnant, were shot dead after nightfall on a busy highway close to the flashpoint West Bank city of Hebron.
The White House strongly condemned the attack and urged that it not be allowed to sabotage the negotiations. It took months of U.S. pressure to bring the two sides to the table.
Abbas, who also met Clinton before the summit, condemned any operation that targets civilians, Palestinians or Israelis. Hamas calls the Western-backed Abbas, who governs only in the West Bank, a traitor for talking to Israel.
Egyptian President Hosni Mubarak and Jordan's King Abdullah will attend the White House dinner, expanding the dialogue to two influential Arab neighbours who have made peace with Israel and could promote broader Arab-Israeli reconciliation.
(Additional reporting by Jeffrey Heller and Andrew Quinn in Washington; Allyn Fisher-Ilan in Jerusalem, editing by Angus MacSwan)