There are so many possibilities and unknowns in this equation, that it is almost impossible and presumptuous for an outsider to make educated guesses. Having confessed to the lack of certainty in this game of bluff or chicken, let me take the liberty of attributing a rationale to the policy of a group of people, not unfamiliar with tyranny, oppression and discrimination.
The Israelis are not unfamiliar or too far removed from the history of tyranny, prejudice and holocaust, and yet why do they insist on a Bantustan like Palestinian state without relinquishing their hold on the West Bank and other sundry places of no strategic or military importance. It would be foolish to ascribe it to obstinacy. The real reason, in my humble opinion, is the desire to control the distribution and source of water and not allow alien and hostile hegemony of this essential lifeblood of mankind. There may be another hidden purpose like occupying territory, to meet the needs of the Right of Return, denied selectively to the Palestinians, and the morbid fear of a Palestinian majority in a Jewish state. None of these hypothetical conjectures justify, condone or legitimize the atrociously tyrannical behavior of the occupying forces of Israel, nor do they seek to defend, laud or rationalize their hatred, cleansing or oppressive tactics. Most people are unaware of the severe water crisis faced by Israel and its dependency on the rivers Jordan and Litani, and the flow from the Golan Heights. It is to the credit of the Israeli propaganda machine, that this dilemma and problem is never allowed to surface for fear of it being labeled as a land grabber or bullying to dominate and control the water resources of much of the disputed Middle East.
A serious plan for peace may succeed, if it guarantees the access of Israel to water or subsidizes its hydrological independence by providing cheap fuel for a desalinating plant to allay its fears of water dependency. Its morbid fears of a militant and belligerent Palestinian state, too close for comfort or adequate warning of a hostile barrage of missiles armed with chemical, biological or nuclear weapons, also deserves legitimate consideration, but is not an insurmountable obstacle to sane negotiation.
It should be clear even to a blind hawk like Sharon that aggressive and indiscriminate retaliation only aggravates the problem because of hydra-headed suicide bombers, who are brainwashed, fanatic and pushed to desperate measures, irrespective of the consequences. The ridiculous hope of marginalizing the PLO or Arafat, in the hope of dictating terms to a pliant and susceptible to browbeating replacement, is a pipe dream of people out of touch with reality. I am painfully aware of the incompetence and corruption of the Palestinian Authority, but the ham handed approach will result in another Hamid Karzai, whose rule barely extends to the front porch of his house and that too under guard by American troops. Ah well, there is none as blind, as one who does not wish to see!!!