* PLO and Hamas say they agree to Palestinian reconciliation
* Netanyahu says unity drive bad for peace
* Israeli-Palestinian diplomacy faces April 29 deadline
* Abbas says unity does not contradict talks (Adds U.S. disappointed and worried for future of peace talks, graf 7)
By Nidal al-Mughrabi and Noah Browning
GAZA/RAMALLAH, West Bank, April 23 (Reuters) - The Gaza-based Islamist group Hamas and President Mahmoud Abbas's Palestine Liberation Organization (PLO) announced a unity pact on Wednesday, deepening a crisis in U.S.-brokered peace talks with Israel.
The move, coming after a long line of failed efforts to reconcile after seven years of internal bickering, envisions a unity government within five weeks and national elections six months later.
"This is the good news we tell our people: the era of division is over," Hamas Prime Minister Ismail Haniyeh said to loud applause at a Palestinian news conference also attended by representatives of the PLO.
Israel said after the announcement that Abbas had chosen Hamas over peace, and cancelled a session of U.S.-brokered talks with the Palestinians that had been scheduled for Wednesday night in Jerusalem.
Israeli Prime Minister Benjamin Netanyahu said in a statement that Abbas "chose Hamas and not peace. Whoever chooses Hamas does not want peace."
Israeli Channel 2 TV said Netanyahu would convene an emergency session of his security cabinet on Thursday to discuss his response.
Washington said it was disappointed by the deal which State Department spokesman Jen Psaki said "could seriously complicate our efforts - not just our efforts but the efforts of the parties to extend their negotiations."
Along with the United States and the European Union, Israel views Hamas as a terrorist organization and says Abbas' efforts to unify with the group show he is not serious about extending the troubled negotiations.
The talks, aimed at ending its decades-old conflict with the Palestinians and establishing a Palestinian state in the West Bank and Gaza, are scheduled to end on April 29.
Palestinians have long hoped for a healing of the political rift between the PLO and militant Hamas, which won a Palestinian election in 2006 and seized control of the Gaza Strip from forces loyal to Western-backed Abbas in 2007.
But reconciliation dreams have been dashed repeatedly in the past. Since 2011, Hamas and Fatah have failed to implement an Egyptian-brokered unity deal because of disputes over power-sharing and the handling of the conflict with Israel.
Hamas has battled Israel, which it refuses to recognise, while Abbas's Fatah party has remained in control of the Palestinian Authority in the occupied West Bank and pursued years of fruitless talks with Israel.
Abbas said the pact would not interfere with peace efforts.
"There's no contradiction at all between unity and talks, and we're committed to establishing a just peace based on a two-state solution," he said in a statement following the deal.
Egypt's foreign minister Nabil Fahmy welcomed the deal, saying in a statement he hoped it would "support the Palestinian position in the peace talks". Qatari Foreign Minister Khalid bin Mohamed al-Attiyah congratulated the Hamas prime minister.
The approval of the two influential Arab states, which have been at loggerheads over the role of the Hamas-linked Muslim Brotherhood, implied the agreement had backing from the region as a whole.
It could give Abbas a measure of sovereignty in Gaza and help Hamas, hemmed in by an Israeli-Egyptian blockade, become less isolated.
But Gaza analyst Talal Okal said previous unity agreements signed with great fanfare had amounted to nothing, and the future of this deal may depend on whether the sides agree to extend U.S.-brokered peace talks.
"Will it materialise or not? Let's wait for April 29th. What will happen if negotiations are extended?" Okal said.
Minutes after the announcement, Israel launched an air strike on northern Gaza, wounding 12 people, including several small children, local medical officials said.
The Israeli military said it had carried out a "counter-terrorism operation in the northern Gaza Strip," and that it had not identified a hit, suggesting it may have missed its target.
U.S. Secretary of State John Kerry revived the peace talks in July after a nearly three-year hiatus.
The negotiations stalled this month when Israel refused to carry out the last of four waves of prisoner releases unless it received assurances the Palestinian leadership would continue the talks beyond the end of April.
After Israel failed to free the prisoners, Abbas responded by signing 15 international treaties, including the Geneva Conventions on the conduct of war and occupations. Israel condemned the move as a unilateral step toward statehood.
Talks were last held on Tuesday, with no reported progress. (Additional reporting by Jeffrey Heller in Jerusalem and Ali Sawafta in Ramallah; Writing by Noah Browning; Editing by Sonya Hepinstall)