Negotiations between Hamas, which controls the government, and the rival Fatah faction of President Abbas broke down just before midnight on Monday. In an attempt to head off growing chaos in the Palestinian territories and restart peace talks with Israel, Abbas has picked up on an 18-point manifesto that accepts a Palestinian state in the West Bank, Gaza Strip and east Jerusalem, implying recognition of Israel in the process. Abbas gave into pressure to give Hamas three extra days to accept it before he calls for a referendum that would likely be held in July.

The document was created by Palestinian prisoners held in Israeli custody and has been seized upon by moderates hoping to end crippling Western sanctions  imposed on the Palestinian Authority since Hamas, which professes militant Islam and refuses to renounce violence, won parliamentary elections in January. Despite the end of foreign aid, Hamas also refuses to recognize Israel's right to exist.

Abbas surprised Hamas late last month by giving an ultimatum  to back the proposal or face a referendum. On Tuesday, Hamas spokesman Sami Abu Zuhri said talks should continue without the threat of an impending vote. "You cannot raise the sword of ultimatum, you cannot raise the issue of a referendum while you are talking about dialogue," he told reporters in Gaza. By calling a referendum, Abbas said, he could circumvent the elected government.

Opinion polls currently show that Abbas would win a referendum. But if he lost, his Fatah faction would be discredited and he might be forced to step down from the office of president. On the other hand, if he wins, he could use it as a pretense to sack the Hamas-led government and return to peace talks with the Israelis. Israeli Foreign Minister Tzipi Livni said Monday that the manifesto is an internal Palestinian issue, but the government in Jerusalem clearly rejects key points.

Some observers believe the showdown could pitch the region into a new phase of violence. The armed wings of Hamas and Fatah now have frequent shootouts. "We're approaching very tragic days," Palestinian political analyst Bassem Ezbidi told Reuters. "Hamas will work on two fronts, it will flex its muscles in Gaza and this could get bloody, or they will boycott the referendum. I think they will favor the boycott."

EU considers aid options

At the same time the dispute amongst the Palestinians is escalating, the European Union is preparing to propose new ways of channeling international aid to the Palestinians while bypassing the Hamas-led government.

"We hope to be able to present a new and more detailed proposal, perhaps before the end of the week, but very soon in any case," said Emma Udwin, external affairs spokeswoman for the European Commission. The EU is the largest source of aid for the Palestinians, sending some €500 million ($640 million) a year.

On Tuesday, the Associated Press reported Hamas had smuggled hundreds of thousands of dollars into the Gaza Strip in recent weeks to pay essential employees, as well its new militia, which is being used to battle Fatah fighters. The Israeli army believes transporting cash in suitcases across the Gaza-Egypt border is the most common method.