* Far-right minister: peace process has exhausted itself
* Negotiating teams make progress toward deal to extend peace talks
* Israel's chief negotiator derides annexation proposal (Adds negotiators discuss compromise to break negotiations impasse)
By Crispian Balmer
JERUSALEM, April 10 (Reuters) - A senior Israeli minister has urged Prime Minister Benjamin Netanyahu to annex a swathe of Jewish settlements in the occupied West Bank, saying peace talks with the Palestinians were dead.
However an Israeli source confirmed media reports that the sides were mulling a possible deal to extend the troubled talks beyond an April 29 deadline, through to the start of next year.
The U.S.-sponsored negotiations came close to collapse last week amidst mutual recrimination and although the two sides are seeking to overcome the crisis, Netanyahu started imposing punitive sanctions and ordered a partial freeze on contacts with the Palestinians on Wednesday.
Economy Minister Naftali Bennett, who is head of the ultra-nationalist Jewish Home party, wrote to the prime minister late on Wednesday saying Israel should extend its sovereign territory to a number of major settlement blocs.
Mega settlements, such as Ma'ale Adumin, are built on land seized in the 1967 war - territory the Palestinians want for their future state. Successive governments have said the blocs, deemed illegal under international law, should remain part of Israel in any negotiated deal with the Palestinians.
"It is clear that the current process has exhausted itself and that we are entering a new era," said Bennett, urging Netanyahu to annex a number of large settlements.
"These are areas which enjoy a wide national consensus, have security implications and have historical significance for the State of Israel."
Netanyahu made no comment on Bennett's request, but is likely to face strident calls from within his own rightist Likud party to annex the blocs, home to an estimated 350,000 Israelis, if the latest peace talks implode.
Such a move would almost certainly set off a storm of international condemnation, and Israel's chief negotiator, Tzipi Livni, said Bennett was acting like a "provocative child" who needed parental restraint.
"If you want to go totally crazy, keep it up until we can no longer make a deal and lose everything we hold dear," Livni, who serves as justice minister, wrote on her Facebook page.
Despite the crisis in peace talks, Israeli and Palestinian negotiators met for a third time this week on Thursday. Israeli and Arab media reports said they discussed proposals to break through the logjam and extend negotiations though early 2015.
An Israeli source speaking on condition of anonymity confirmed a proposal for Israel to freeze some settlement construction and free more than 400 Palestinian prisoners, while Palestinian President Mahmoud Abbas would freeze or rescind his signing of 15 world documents that angered Israel this month.
"It's on the agenda but nothing has yet been agreed upon," the source said, suggesting some work was still required before any deal could be finalised. Officials on both sides seemed confident the impasse in the talks could be broken.
"I would bet on the possibility of them reaching a deal to continue negotiations between now and the end of the month. The differences are not so substantial," said Ghassan Khatib, a former Palestinian government minister and now academic at Birzeit University in the West Bank.
Settlements have been a constant source of aggravation between Israelis and Palestinians, with construction of new Jewish homes in the West Bank rising 123 percent year-on-year in 2013, a surge that coincided with the resumption of talks.
U.S. Secretary of State John Kerry said this week that the announcement last week of tenders for 700 new homes in East Jerusalem was the immediate cause of the negotiations crisis.
An official in Netanyahu's office said Israel was "deeply disappointed" by Kerry's remarks, signalling clear tensions in relations between the two allies.
(Additional reporting by Allyn Fisher-Ilan and Jeffrey Heller; Editing by Mark Heinrich)