* West Bank, East Jerusalem settlements seen as illegal
* U.S. trying to salvage peace talks
* Deal to free Israeli spy could lead to talks extension
* Israeli spy jailed in U.S. could be part of mix (Adds Kerry to return to region on Wednesday, paragraph 7)
By Lesley Wroughton and Maayan Lubell
JERUSALEM, April 1 (Reuters) - Israel may impose a partial settlement freeze to keep U.S.-brokered peace talks with the Palestinians alive, an Israeli source close to the negotiations said on Tuesday.
A halt to Israeli state-backed construction in the occupied West Bank would be part of a proposed package that includes the release of Jonathan Pollard, an Israeli spy jailed in the United States, and hundreds of Palestinians held by Israel.
Israeli settlements in the West Bank and East Jerusalem, land captured in the 1967 war and which Palestinians seek for their state, have been a major stumbling block in the talks that began in July. Most countries view those settlements as illegal.
The source, who is close to talks held on Monday and Tuesday between Netanyahu and U.S. Secretary of State John Kerry, said that in return for the Israeli steps, Palestinians would agree to extend the peace talks beyond an April 29 deadline into 2015.
Israel last imposed a partial settlement freeze in 2009 in a bid to restart negotiations. Palestinians returned to the talks in 2010 but they collapsed within weeks after Prime Minister Benjamin Netanyahu refused to extend the 10-month moratorium.
"The (new) settlement freeze does not include East Jerusalem, private construction or building of public institutions," the source said, speaking on condition of anonymity.
Another official involved in the negotiations said the Israeli government "will adopt a policy of restraint when it comes to state tenders for construction" in the West Bank.
There was no immediate Palestinian comment on the emerging deal.
Kerry, who flew to Brussels on Tuesday for a NATO meeting, will return to the Middle East on Wednesday to meet Palestinian President Mahmoud Abbas in the West Bank town of Ramallah, State Department spokeswoman Jen Psaki said.
The negotiations, aimed at creating a Palestinian state and ending a decades-long conflict, have also stalled over Palestinian opposition to an Israeli demand that the country be recognised as a Jewish state. They say this conflicts with their own narrative for nationhood.
The talks appeared to be have been on the brink of collapse at the weekend when Israel failed to press ahead with a promised release of several dozen jailed Palestinians.
Under the proposed deal, Israel would go ahead with the release of a fourth group of Palestinians, the last among the 104 it pledged to free as part of confidence-building measures under an agreement that led to the renewal of the talks.
That group of inmates includes 14 Arab citizens of Israel, a potential political obstacle for Netanyahu. Far-right members of his coalition view the release of Israeli Arabs in any deal with the Palestinians as a challenge to Israel's sovereignty over its Arab minority - 20 percent of the population.
In addition, Israel would free 400 other Palestinian prisoners, including women and minors, who have not been convicted of killing Israelis and have almost completed their sentences.
Palestinians regard compatriots jailed by Israel as heroes in their quest for an independent state. Israel views them as terrorists.
Freedom for Pollard, a U.S. citizen and former navy analyst who pleaded guilty in 1987 to charges of spying for Israel, could provide Netanyahu with the leeway he may need to persuade hardliners in his governing coalition to agree to the partial settlement freeze and the wider prisoner release.
U.S. intelligence agencies have long opposed any early release of Pollard, and U.S. officials said no decision has yet been made. Pollard, now 59, is due for parole next year.
Sources close to the peace negotiations said Pollard could be freed before the Jewish holiday of Passover, which begins in two weeks' time. A spokesman for Pollard's wife, Esther, declined comment.
Kerry, who has visited the region more than 10 times in little more than a year as he strives for a peace deal, met separately with Netanyahu and Palestinian chief negotiator Saeb Erekat before leaving on Tuesday for a NATO meeting in Brussels.
The focus of his Middle East mission appeared to have shifted from reaching an elusive framework agreement by April 29, including general principles for a final peace accord, to simply keeping both sides talking beyond that deadline. (Writing by Maayan Lubell; Editing by Jeffrey Heller and Louise Ireland)