* Israeli settlement issue to overshadow talks
* Germany has been one of Israel's strongest allies
* But settlement plan has disturbed Berlin
* Netanyahu feels betrayed by German position
By Alexandra Hudson
BERLIN, Dec 4 (Reuters) - Benjamin Netanyahu faces a dressing down from Angela Merkel on Wednesday over his plans to build more Israeli settlements, a policy that has incensed Europe and left even Germany, one of Israel's strongest allies, questioning his commitment to peace.
The issue will overshadow consultations between the German and Israeli governments on issues ranging from Israel's defence and security to greater cooperation in science and research and could further strain already cool working relations between Netanyahu and the German chancellor.
The Israeli prime minister is still smarting from what he considers Berlin's betrayal after Germany abstained in a U.N. vote last week that upgraded the Palestinians' status to "non-member state" from "observer entity".
He had wanted Berlin to vote no.
Netanyahu will stop briefly in Prague on his way to Berlin to thank the Czechs for being the only European state to join Israel and the United States in opposing the resolution, underscoring how important the issue was for him.
Germany says its decision was based on the view that the Palestinians were justified in desiring their own state, but had chosen the wrong way of pushing the issue. It argued that moves in the United Nations rather than talks in the Middle East would only hamper peace and push both sides further apart.
So far, the Germans appear to have been right.
A day after the U.N. General Assembly backed the Palestinian bid, Israel said it would build new dwellings for Jewish settlers.
Such projects, on land Israel captured in a 1967 war, are considered illegal by most world powers and have routinely drawn condemnation from them.
One of the areas Netanyahu said would be subject to preliminary planning work is the so-called "E1" zone east of Jerusalem, a prospect that has stoked particular alarm.
"E1 is not just another settlement. E1 is of enormous strategic importance. E1 ... would cut off East Jerusalem once and for all from the West Bank, thereby making a two-state solution practically impossible," said Ruprecht Polenz, a member of Merkel's Christian Democrats and head of the Foreign Affairs Committee of the Bundestag lower house.
Should E1 go ahead, Netanyahu and Foreign Minister Avigdor Lieberman would "bury the dream of a democratic, Jewish state" by creating instead an entity that would have to include a large Palestinian population, he said in emailed comments to Reuters.
"The (German) government should do everything to turn Israel from this path in the coming inter-governmental talks," he said.
Germany frequently stresses it will always have a unique relationship with Israel and bear responsibility for the security of the Jewish state after the Nazi-perpetrated Holocaust.
Merkel issued a video message on Saturday saying how much she was looking forward to "friendly discussions" with Netanyahu when they dine together on Wednesday.
She again backed Israel's right to defend its citizens from attack, leaving it to her spokesman Steffen Seibert to issue a surprisingly strong warning on Monday over the settlement plan.
"The Israeli government is sending out a negative message with this move. It is eroding trust in its willingness to negotiate, and the land for a future Palestinian state is disappearing further," Seibert said.
A senior Israeli government official said the Jewish state hoped Merkel would not repeat the admonition herself in public.
Polenz said that Israel should seize the initiative and launch fresh peace talks instead of settlement building.
"I am concerned that with continued settlement building the time frame for a two-state solution will probably run out within the next two years," he said.
Israel cites historical and Biblical links to the West Bank and Jerusalem, saying the future of settlements should be determined through negotiations.
Germany's response may seem muted compared with the strong chorus of criticism from other European capitals, but in German terms it is a notable step.
"We have a unique relationship stemming from our history, and are in a fundamentally different position from our European neighbours. Friendship cannot be questioned, whatever the relations between our governments," said Reinhold Robbe, a former Social Democrat lawmaker and president of the German-Israeli society.
Germany's commitment to Israeli security includes sales of arms. In March, Berlin said it would sell Israel a sixth military submarine and shoulder millions of euros of the cost.
Just last week, according to news magazine Spiegel, Germany's Federal Security Committee agreed to the export of shoulder-fired anti-tank weapons and bunker-busting w e apons to Israel to help it defend itself from attacks by Hamas from Gaza.
A defining feature of Merkel's time as chancellor has been her eagerness to engage with Israel herself, rather than hand the portfolio to her foreign minister, as her predecessor Gerhard Schroeder tended to do, Robbe said.
But this means she must now engage in difficult talks with Netanyahu directly and put all subjects on the table, he said.
The two governments will hold a joint session on Thursday when Netanyahu and Merkel will also give a news conference. (Additional reporting by Jeffrey Heller in Jerusalem; Editing by Gareth Jones and Andrew Osborn)