(Adds dropped word in second para)
* Complicating troubled peace efforts Israel says will withhold tax transfers
* Despite crisis, negotiators seek progress toward deal to extend peace talks
* Israel's chief negotiator derides annexation proposal by far-right cabinet member
By Crispian Balmer
JERUSALEM, April 10 (Reuters) - Israel imposed economic sanctions against the Palestinians on Thursday in retaliation for their leadership signing international conventions, moves that further complicate U.S. efforts to keep peace talks from collapsing before an April 29 deadline.
An Israeli official, speaking on condition of anonymity, said the Jewish state would deduct debt payments from tax transfers which the Palestinian Authority routinely receives, and limit the self-rule government's bank deposits in Israel.
On Wednesday, Israel said it was limiting its contacts with Palestinian officials, citing Palestinian President Mahmoud Abbas's signing of U.N. human rights conventions last week.
Israel viewed that move as an attempt by the Palestinians to assume the trappings of statehood outside the framework of the U.S.-backed negotiatons.
Abbas, for his part, has accused Israel of violating a commitment to release two dozen prisoners at the end of March, the last group of about 100 Israel pledged to free, including Palestinians convicted of killing Israelis, when the negotiations resumed in July.
The official said Israel had "decided this evening to deduct debts of the Palestinian Authority to Israel from tax revenue transfers," but would not say what amounts were involved.
The revenues which Israel collects on goods bound for the Palestinian market amount to about $100 million a month and accounts for about two thirds of the Palestinian budget.
Based on Israeli media reports, Palestinian debts to Israel for such services as electricity total at least a month's worth of revenue.
Israel also said it would suspend its participation in a gas exploration project off the coast of the Gaza Strip.
Senior Palestinian official Yasser Abed Rabbo denounced the measures.
"These sanctions will not scare us and they're evidence to the world that Israel is a racist occupation state that has resorted to the weapon of collective punishment in addition to other practices including settlements and their expansion and the denial of our most basic rights as a people," he said.
Even before the latest flurry of tit-for-tat measures, the talks, aimed at creating an Palestinian state and ending a decades-long conflict, had stalled over the issue of Israeli settlements in the occupied West Bank and East Jerusalem, and the Palestinian's refusal to formally recognise Israel as a Jewish state.
Most countries view the settlements, built on land captured in the 1967 Middle East War, as illegal.
Despite the crisis, there were signs of a deal in the works to rescue the talks.
Israeli and Palestinian negotiators, meeting for a third time this week on Thursday, discussed proposals to break the logjam and extend negotiations through to early 2015, an Israeli source said, confirming Israeli and Arab media reports.
In Washington, the U.S. State Department said the two sides were making progress but dismissed suggestions an agreement to extend the talks had been struck.
"The gaps are narrowing but any speculations about an agreement are premature at this time," State Department spokeswoman Jen Psaki told a regular briefing.
An Israeli source, speaking on condition of anonymity, said the sides had discussed a proposal for Israel to freeze some settlement construction and free more than 400 Palestinian prisoners, while Abbas would freeze or rescind his signing of the international documents.
A far-right Israeli cabinet minister, Naftali Bennett, called earlier for Israel to annex a swathe of Jewish settlement blocs in the occupied West Bank, pronouncing the talks as dead.
"It is clear that the current process has exhausted itself and that we are entering a new era," Bennett, head of the ultra-nationalist Jewish Home party, wrote in a letter to Prime Minister Benjamin Netanyahu.
Netanyahu made no comment on Bennett's request, but is likely to face calls from within his own rightist Likud party to annex the blocs, home to an estimated 350,000 Israelis, if the talks implode.
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 social media page.
(Additional reporting by Allyn Fisher-Ilan and Jeffrey Heller in Jerusalem, and Arshad Mohammed in Washington; Editing by Angus MacSwan)
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