In a speech before Israeli students in Jerusalem, Mr Obama said a sovereign Palestinian state was the "only path for true security" in Israel.
Palestinians had "a right to be a free people in their own land", he said.
Earlier in Ramallah, he urged Palestinians to drop their demand for a freeze in Israeli settlement building.
Mr Obama's three-day visit to Israel and the West Bank is his first as president.
His speech - at Jerusalem's convention centre and addressed to the Israeli public - recounted the history of the Jewish people, and stressed, as he has done throughout his visit, the close bond between Israel and the US.
But he said their country had reached a crossroads and that "the only way for Israel to to endure and thrive as a Jewish and democratic state is through the realisation of an independent and viable Palestine".
He urged Israelis to "look at the world through their eyes", saying the Palestinians' right to self-determination and justice must be recognised".
Mr Obama said Israelis had a "true partner" in Mahmoud Abbas, president of the Palestinian Authority, and in the PA's Prime Minister Salam Fayyad.
He also criticised the building of Israeli settlements on land which Palestinians want to be part of a future state as being "counterproductive to the cause of peace".
Settlement building has been the major stumbling block in the peace process, with Palestinians long insisting it must stop completely before stalled talks can restart.
Mr Obama has previously backed that view and told reporters in Ramallah on Thursday that he still believed settlement activity could not "advance the cause of peace".
Source: BBC News
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