Israel is offering Palestinian gunmen inside the Church of the Nativity trial in Israel or permanent exile.
It follows the two-week-old standoff at the Bethlehem church.
There was no immediate Palestinian response, but the proposal appeared virtually certain to be rejected.
The latest Israeli proposal comes after a Palestinian was reportedly shot dead in a hostel adjoining the church.
Israeli Prime Minister Ariel Sharon raised the latest Israeli proposal with US Secretary of State Colin Powell, who was to pass it on to the Palestinian leadership, said Sharon spokesman Raanan Gissin.
It wasn't clear to where they would be exiled.
"We want to resolve the standoff at the Church of the Nativity, but we're not going to let the terrorists just walk away," Gissin said.
Palestinian gunmen shot off the church door and entered on April 1 as they were being pursued by Israeli forces chasing suspected Palestinian militants.
About 250 people are inside the church, including gunmen, Palestinian policemen and clergy.