Great post Bert.
Thought I'd wade in with a few points to the discussion:
First, this is a map of the original Palestine Partion, as created by the UN partition plan of 1947, divided roughly in half, between Arabs and Jews. In the 1948 war, Israel rightly and competently defended itself, but annexed the Arab half in the process. Both parts were subsequently recognized as the State of Israel by the international community (except theArab/Muslim states until recently). This is now part of Israel, and is not to be confused with the current land dispute over the Occupied Territories, which is something different. The Arab 'citizens' of Israel mentioned earlier are the Arabs who remained in their homes and were given citizenship in the new country, but many fled to neighbouring countries and became refugees.
http://www.jewishvirtuallibrary.org/jsource/History/partmap.html
The Occupied Territories, not depicted in the map, are the areas of Egypt, Syria, and Jordan which were captured by Israel in the 67 war and upon which Israel built settlements and the wall. This is the disputed Israeli territory, although a 2-state solution will probably include some of the original Arab territory form the '47 plan. The controversy over the wall, as was previously noted, is that it is built on this disputed territory, not within Israel's recognized boundaries, and around most of the settlements that Israel built on occupied land.
With regard to the Arab Israeli Citizens, they do enjoy SOME of the rights of citizenship, like the right to vote, but are barred from most public sector jobs by either law or common practice, including public utilities senior govgovernmentd of course the military. Many private employers also require proof of military service from applicants and make no distinction for Arabs who are banned from military service. Also, Arabs are banned from living in designated Jewish areas and the boundaries on Arab towns are permanently fixed to prevent expansion. Building permits are almost never issued to Arab towns, and those who build or modify thier their without permits are either fined or have their homes demolished. To Israel's credit, the Supreme Court is now slowly bringing reform, and challenging discriminatory laws, which is a complement to the integrity of their system. Israel is a democracy, but it is a democracy similar to the US before the civil rights movement. The govt still enforces segregation and Arab citizens are still second-class citizens in many regards.
If only moderates from both sides could find enough common ground and patience to get the peace process on track.