The creation of a new Israeli government was hanging in the balance on Friday after a powerful ultra-Orthodox party said it would not join a coalition headed by prime minister designate Tzipi Livni.
  
The decision by Shas could see the country go to an early general election, a move likely to cast a long shadow over already sluggish Middle East peacemaking.
  
Livni, leader of the governing Kadima party and currently foreign minister, issued an ultimatum on Thursday warning that if she was unable to form a coalition government by a Sunday deadline, snap elections would be called.
  
She has been battling to win the support of smaller parties, including the ultra-Orthodox Shas, which has often played the role of kingmaker in previous Israeli coalition governments.
  
Last week the centrist Kadima party, which has 29 seats in the 120-member parliament, reached a draft coalition agreement with Labour which has 19 MPs.
  
But major differences emerged in negotiations with Shas, the third largest party in Israel with 12 deputies, whose support was seen as vital if she Livni is able to form a viable government.
  
And on Friday Shas said it had failed to secure two key requirements -- an increase in family allowances and a guarantee that the future of occupied east Jerusalem would not be negotiated in peace talks with the Palestinians.
  
Under such conditions, it said, "we cannot take part in a Livni government."
  
The decision was made by Shas's powerful spiritual leader Rabbi Ovadia Yosef after consulting the party's supreme authority.
  
"All through the negotiations we insisted on two points -- substantial help for the least favoured people and the defence of Jerusalem," Shas said in a statement.
  
"If the status of Jerusalem is not strengthened and we give the impression that Israel's capital could be part of a deal, that could have repercussions for all future negotiations."
  
President Shimon Peres asked Livni on September 22 to form a new government after she was elected Kadima leader to replace Prime Minister Ehud Olmert, who has resigned to battle a wave of graft allegations.
  
"In theory, Livni can form a minority government with less than 60 seats from the 120 in the Knesset but she would need the support of Arab MPs, something that part of Kadima opposes," Gideon Doron, political science analyst at Tel Aviv University, told AFP.
  
"The Shas party remains the key to the formation of a government, but this party is itself split between the wish to retain power and sympathies of its base for Benjamin Netanyahu," he said, referring to the leader of the right-wing Likud party.
  
Shas currently has four ministerial posts in the Olmert coalition.
  
Livni, a 51-year-old former Mossad agent, is seeking to become Israel's second woman prime minister after Golda Meir, who held office from 1969 to 1974.
  
"Decision time has come," she declared on Thursday.
  
"I have just spoken with the president to tell him I will meet him on Sunday to announce my decision: either we form a new government or we go to new elections."
  
If it proves impossible to form a new government, general elections will be scheduled for 2009 and polls indicate they could bring Likud and former premier Netanyahu to power.
  
As foreign minister, Livni has been leading US-backed negotiations with the Palestinians that were revived at a US conference in November but have made little visible progress since.
  
On Thursday, Netanyahu accused Livni of wanting to divide Jerusalem, whose fate is one of the thorniest issues at the heart of the Israeli-Palestinian conflict.
  
Palestinians have demanded mostly Arab east Jerusalem -- seized and annexed by Israel in the 1967 Six Day war in a move not recognised internationally -- as the capital of their future state.
  
Israel considers the entire city its "eternal, undivided" capital, although Olmert last month said that Israel would have to give up almost the entire occupied West Bank including east Jerusalem as the price for peace.