Hmm, I'm not so sure. I honestly don't think the Palestinian leadership have ever been ready for peace. I mean, the first intifada was clearly justified and I couldn't excuse Israel's behaviour then. But the first intifada was a popular genuine uprising against a de facto oppressor who, at that point, really wasn't listening. Things were very different with the second intifada which had no justification other than Arafat not wanting his legacy to be the one which gave up on the right of return. He was a megalomaniac with dreams of grandeur.
When I think back to that time in israel (I was there almost exact same time as you, had also lived there previously including service in the Idf but left for a few years), I remember things which are almost unthinkable now. I remember Malha mall in Jerusalem being full of cars with Jordanian plates! I remember taking a couple of courses in English in public administration at the Hebrew university with quite a few participants from the PA, I remember Palestinians coming (almost) freely into Israel. Sure, there were issues, but there was a peace process. I blame Arafat for derailing that process and the American side of things corroborates this.
Actually, most orthodox men DO serve in the Idf, including most settlers (often through the hesder yeshivot). It's the ultra orthodox, the Haredim, who don't. But they, for the most part, aren't all that bothered about the settlements. They just want their benefits, their schools, and to keep a monopoly on Jewish religious life in Israel (especially marriage and divorce). But I agree, the hold the settlers have, with their messianic religious driven Zionism, over Israeli politics seems very odd to me. I remember the evacuation of the Jewish settlements in gaza and how upset people got, even people who don't support the settlers. The thing about the settlers is that they are often really amazing people - intelligent, driven, altruistic, community minded - other than their crazy religious blindless regarding the settlements and what's become now racism as well. It's so sad to see all their energies and productive talents going into such a destructive enterprise!