"(This) will surely have positive influence on other states to follow the same steps," Palestinian Foreign Minister Riyad al-Malki told a news conference in Reykjavik.
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"Iceland didn't only talk the talk, we walked the walk," Icelandic Foreign Minister Ossur Skarphedinsson said. "We stood by our word, we have supported the Palestinian cause and today will not be the end of that, we will continue to do so."
East European countries that were once part of the old Soviet bloc, as well as Cyprus - all of them now European Union members - previously recognized Palestine.
Israel and the United States have opposed any recognition of a Palestinian state not based on the outcome of negotiations. Washington's major west European allies echo this position. Iceland is outside the EU.
In late September, Palestinian President Mahmoud Abbas asked the United Nations to recognize a Palestinian state in the West Bank and Gaza with East Jerusalem as its capital. The UN at present classifies Palestine only as an observer "entity".
Leading the way?
Iceland led the way in recognizing the independence of the three Baltic states after the 1991 collapse of the Soviet Union.
Middle East peace talks have been suspended for more than a year. Malki said he wanted negotiations to restart.
"We have committed ourselves to the process of negotiations and we continue to commit ourselves to the process of negotiations with the Israelis," he said. But the peace process was "going nowhere at the moment".
"Actually we are only seeing setbacks. The current Israeli government is not interested in peace and the international community is not doing what is needed," Malki said.
Israel has said it is open to resuming negotiations without preconditions.
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