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Palestinian residents of East Jerusalem are permanent residents, but not citizens, of Israel. Therefore, they are not eligible to vote in the national elections (for the Knesset). However, they are eligible to vote in Jerusalem Municipality elections -- but the vast majority continue to adhere to a boycott and do not participate, despite the fact this means they have absolutely no representation in local matters which have affected them deeply -- and, largely, adversely. A few East Jerusalem Palestinians regret this boycott, and the effect of this lack of representation -- but they have not amassed the weight of public opinion behind them. The Palestinian Authority leadership does not encourage East Jerusalem Palestinians to participate in the Jerusalem municipal elections. On the other hand, since the Oslo Accords in the mid-1990s, East Jerusalem Palestinians have had the right to participate in Palestinian Legislative Council and Presidential elections -- a bit of a stretch from the letter of the Oslo Accords, which authorized Palestinian residents of East Jerusalem to vote in the first Legislative Council elections. However, on each occasion that has offered the East Jerusalem Palestinians a chance to vote in the PA elections, Israeli officials have made difficulties and obstacles -- ranging from problems with registration, to a prohibition on political campaigning, to inaccessibility of balloting places (in Israeli Post Offices). And now, there is The Wall, which puts probably as many as 100,000 Palestinian residents of East Jerusalem on the wrong side, causing difficult access. The result is that Palestinian residents of East Jerusalem have the right to vote in two elections (Jerusalem municipality + Palestinian Authority "national" elections for President and parliament), but most do not, or can not, participate in either...
It is theoretically possible for Palestinian residents of East Jerusalem to apply for Israeli citizenship -- but many have not done so, in part for the same reason that they boycott the Jerusalem municipal election: they do not want to recognize the Israeli occupation as lawful. In earlier years, it was relatively easy for the few Palestinian residents of East Jerusalem who were interested to obtain Israeli citizenship. In recent years, there was an Israeli "tightening up" which made it much more difficult for these Palestinians to obtain Israeli citizenship. Now, I have just been told, it has suddenly become easier again... But, first, an applicant has to travel to Jordan to return the special Jordanian passports that East Jerusalem Palestinians have been using. And, the question for many of them, as they tell me they see it, is not whether it is good or bad to apply for Israeli citizenship, but whether an Israeli passport is more advantageous than a Jordanian passport which allows for travel to other Arab countries...
Israel treats East Jerusalem as a "special case" because: (1) after their conquest in the June 1967 war, it extended its administration and laws to East Jerusalem (which was basically 6 square kilometers including the Old City and close surrounding neighborhoods) ; (2) also in 1967, Israel unilaterally re-drew the boundaries of "Jerusalem" to include the not only the Old City and its near neighborhoods in East Jerusalem -- but also a large additional swathe of other West Bank territory in a crescent of areas surrounding East Jerusalem, from Qalandia (airport) and the Atarot industrial zone north of Jerusalem almost down to Bethlehem in the south, and then called all of this the "Greater Jerusalem municipality", or "Jerusalem".
Then, in 1980, Israel adopted a Basic Law declaring this expanded "Jerusalem" (including the Old City, East Jerusalem, and surrounding territory) as its eternal and undivided capital. Both the UN General Assembly and the UN Security Council have called this move "null and void", but Israel has not backed down or blinked.
This is the "Jerusalem" that Netanyahu said the other day Israel will continue to build in, as it has for the past 42 years. He was not talking only about West Jerusalem, which became part of Israel at its proclamation in May 1948 -- he also meant the areas of East Jerusalem (including the Old City) and other areas of the nearby West Bank that were joined together in 1967 to make the "Greater Jerusalem Municipality". It was not until 2008, during the Annapolis process of negotiations, that Israeli government officials first stated clearly and publicly that in their view the Jewish settlements ("neighborhoods") in East Jerusalem are not on "occupied" land, nor -- in their view -- are they contrary to international humanitarian law.
U.S. Special Envoy George Mitchell reportedly recently explained that Israel has "annexed" these areas -- but it was not reported that Mitchell said this was illegal...
Palestinian officials in various negotiations over the years apparently reportedly given indications that they might be willing to "swap" close neighborhoods like French Hill (now predominantly Jewish, though built on Shuafat land) for Israeli concessions elsewhere.
Adding to the confusion is that the course of The Wall as it has been constructed in and around the "Jerusalem" areaet effectivly unilaterally redefines, once again, what Israel means by "Greater Municipal Jeruslem" -- cutting some Palestinian neighborhoods in two, and putting large numbers of East Jerusalem Palestinians on the West Bank side of The Wall in areas like Qafr Aqab and Semiramis (north of Qalandia checkpoint), ar-Ram, Dahiet al-Bariid, Atara, Ras Khamis, Dahiet as-Salam, and Shuafat Refugee Camp (all north of the Old City), as well as Abu Dis, Bethany, Jabel Mukaber and other areas to the south. So far, despite enormous nervousness, Palestinians with (East) Jerusalem IDs who live in these areas, on what is now the "other" side of The Wall, have not faced a loss of their IDs -- and they still have to pay Jerusalem municipality taxes ("arnona") -- but they do have to cross Israeli military checkpoints to go to the bank, or to the post office, or to school, or to work ...
From the time of Bill Clinton's intervention in the Camp David talks with Yasser Arafat and Ehud Olmert in July 2000, and six months later again in Taba in January 2001, a "principle" was introduced (though it harks back to the British Mandate era) that areas of dense Palestinian population would go to the Palestinian state, while areas of Jewish population would go to Israel. In the Annapolis negotiations, Israel's then-Prime Minister Ehud Olmert applied this "principle" to the "Greater Jerusalem Municipality", in a proposal he submitted in September 2008 to his Palestinian counterparts...