"Everyone knows: without a stop to settlement building there will be no decisive progress in the peace process," he told reporters.
He said US President Barack Obama's new drive to jumpstart stalled Israeli- Palestinian peace talks and to engage with what he called Israel's "difficult" neighbours like Syria and Lebanon, has lent "new momentum to the situation".
"But we know time tends to work against us and that is why a sense of urgency is now required," said Steinmeier, who will wrap up his two-day regional tour on Tuesday with talks in Damascus and Beirut.
The German minister also met Israeli President Shimon Peres and senior Palestinian negotiator Saeb Erakat and was due to hold talks with his ultra-nationalist Israeli counterpart Avigdor Lieberman later on Monday.
Peres told Steinmeier that Netanyahu's conditional endorsement of the creation of a Palestinian state last month signaled that the hawkish leader "wants peace and is ready to start negotiations with the Palestinians."
Steinmeier's stop in Jerusalem comes the same day as a meeting in London between Israeli Defence Minister Ehud Barak and US Middle East envoy George Mitchell amid friction between the two close allies over Israeli settlements in the West Bank.
Steinmeier acknowledged the issue of settlements would be "the most difficult part" of talks with the Israelis but said there is no way around the subject.
He warned that regional powers such as Jordan, Egypt, Saudi Arabia and the United Arab Emirates which have been "constructive" on Middle East peace could jump ship if Israel continues to build on occupied land.
Steinmeier said Europe and Germany have a crucial role to play in laying the groundwork for a Middle East peace backed by Arab neighbours, adding that "Germany has a voice that is heard in the entire region".
"I will continue to press for Israel's difficult neighbours -- in Syria and in Lebanon -- to participate constructively in these efforts toward a two-state solution. If that is successful, it will be to the advantage of all in the region."
Social Democrat Steinmeier, who is also vice chancellor and is challenging Christian Democrat Chancellor Angela Merkel in a September general election, is on his 14th Middle East tour since taking office in November 2005 in a left-right government.
Berlin has described the absence of violence surrounding the Lebanese elections on June 7 and improved relations between Lebanon and Syria as factors that present a "window of opportunity" that Europe must help to seize.
Such steps included the prospect of economic incentives for those neighbours, the construction of roads, schools and power plants for the Palestinians and training Palestinian security forces to help prepare for eventual statehood.
Erakat said he had thanked Steinmeier for Europe's assistance.
"Europe plays a major role in helping peace between Palestinians and Israelis and institution-building, reform, accountability and transparency in the Palestinian Authority," he said.
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