Ah, RB, I think you've touched upon the chicken:egg thing. Also the tit-for-tat. I personally don't think that all Palestinians or Arabs endorse terrorism, but rather a small extreme group like Hamas. Hamas' extreme views may not be the most popular but may be tolerated or turned a blind eye to because they fill a void where the Fatah government or Israelis and even international committee have failed. For example, a lone or small group of radical extremists commit a terrorist act that compels a retaliation by Israel such as sealing the border, squeezing the local economy. The PA does not or can not provide for the people so HAmas steps in. Hamas members bring bread, water, pay for funerals gaining popular support.
Recently, the Palestinians went on strike because the Hamas government has not paid them in 6 months. This is hardly the behavior of Hamas sympathizers and seems to illustate the interrealtionship of the Palestinians.
http://news.bbc.co.uk/2/hi/middle_east/5308330.stm
In short, the Israelis want the acts of terrorism to stop. Typically it would stop then things would relax and a little bit of trust would build and the two sides would continue ever so slowly in talks. But all it takes is for one idiot to ruin the whole thing and cause the whole house of cards to fall. The retaliation by the Israelis doesn't endear them to the Palestinians and the isolated acts of terrorism by extremists doesn't exactly endear the Palestinians to the Israelis either. What happens is everything gets blurred as the emotions get heated up and it becomes a tit-for-tat revenge/retaliation series that never ends.
In my opinion, a line needs to be drawn in the sand - along the lines of enough is enough, all the violence has to stop. Perhaps a base model of the South African variety may povide a good start - the Remorse and Reconciliation. In other words, a clearing of the slate, otherwise, it will just be an endless cycle of violence.
Arabs in Israel seem to be doing just fine (from an observational, anecdotal standpoint). I met many in Jersusalem and Tel Aviv. The stores and restaurants I patronized seemed to be doing well. One notable exception was that the majority of stores like tourist souvenirs etc fared badly when I was there due to the war because tourism was down. I found it ironic that the terrorists hurt their "fellow Arabs" the most. EX: Launching rockets into the West Bank. Also the downturn in tourism due to terrorist activities hurt the Arab merchants the most.
Another point to consider is, the gaza Strip and the West Bank are very different. If I'm not mistaken, the Gaza strip is primarily Hamas controlled and the West Bank is more Fatah territory - Ramallah I think is where their headquarters are.