Ace - though I think the question is usually a red herring, my answer is yes, Israel has a right to exist.
But I have to disagree in the strongest terms with your gut feeling about the amenability of Palestinians to compromise.
Exhibit A is the excellent work of OneVoice, an Israeli/Palestinian/International organization that aims to dispel myths on both sides that the other side's population is 'not a partner for peace'.
OneVoice has conducted extensive grassroots work and hammered out a set of proposals (starting from the Clinton Parameters of 2000) that have 74% support among Palestinians and 78% support among Israelis. This is not just a simple "do you support a two-state solution?" poll, but a concrete set of ideas about what should happen with respect to Jerusalem, refugees, borders, etc. There are a lot of thorny issues, but the idea that there is no plausible middle ground acceptable to both populations is patently false.
OneVoice - Programs: Public Polling Results
Exhibit B is the current prime minister, Salam Fayyad.
Op-Ed Columnist - Fayyad's Road to Palestine - NYTimes.com
Unknown to most casual observers, there is a quiet revolution going on in the West Bank right now. GDP growth is in double-digits and there is a real chance - maybe the last chance - to transform the West Bank into a viable economic entity. But the life-shattering blockade of Gaza poses a long-term threat both to Israeli security and to the future of a Palestinian state - this aside from the sheer human cost.