This is not a sustainable solution. Even assuming the Palestinian citizens acquiesce over the long term, the sizeable Palestinian population outside of Israel but under Israeli military control, in the West Bank and Gaza, are an inherently destabilizing force. On the level of national security, the Palestinian citizens are seen as a potential security threat, as they sympathize with their friends and family who are under Israel's oppressive control. On an ideological level, what if both groups of Palestinians decided to embrace a single democratic state West of the Jordan?
The Palestinian population is growing much faster than the Jewish population. These demographic trends mean that within a decade or so the Palestinians will form a majority West of the Jordan, and the Jews will be a minority - what then?
"If the day comes when the two-state solution collapses, and we
face a South African-style struggle for equal voting rights
(also for the Palestinians in the territories), then, as soon as
that happens, the State of Israel is finished," Prime Minister
Ehud Olmert told Haaretz Wednesday, the day the Annapolis
conference ended in an agreement to try to reach a Mideast peace
settlement by the end of 2008.
"The Jewish organizations, which were our power base in America,
will be the first to come out against us," Olmert said, "because
they will say they cannot support a state that does not support
democracy and equal voting rights for all its residents."
(From http://haaretz.com/hasen/spages/929439.html)
Thus the mainstream Zionist center-left supports a two-state solution, among other reasons, in order to preserve the nationalist Jewish state within Israel. Israel will be assured a permanent Jewish majority, and the Palestinian state will act as a pressure valve for those Palestinians citizens of Israel who are not satisfied with their second-class status. The compromise between democracy and nationalism will therefore be sustainable.
The other alternative, that of the Zionist right, is to explicitly limit the democratic nature of Israel to Jews. By reducing the rights of Palestinian citizens they will be more amenable to various forms of pressure, at the extreme stripping them of their citizenship.
There are some signs indicating the second approach is winning. For one thing, attacks against the democratic elements within Israel. These include curtailing freedom of the press, and arresting journalists: http://www.haaretz.com/hasen/spages/1084996.html
Arresting anti-military activists (I've met some of them, they are really wonderful people): http://www.haaretz.com/hasen/spages/1081366.html http://www.guardian.co.uk/commentisfree/2009/may/05/israel-protest-feminism-draft
Most significantly, a series of laws are being proposed that will take away freedom of speech and possibly even citizenship of Palestinian citizens of Israel. E.g. this loyalty oath would be unacceptable to those who want to see a purely democratic Israel, and is thus a way to strip away the rights of Palestinian citizens for being "disloyal": http://www.haaretz.com/hasen/spages/1088919.html
Stay tuned; these laws will be voted on in the near future.