The "understanding" was reached in Cairo yesterday under Egyptian mediation and was confirmed by leaders of both the Palestinian factions.
Egypt`s official news agency, MENA, said that the factions "reached a complete understanding after talks on all the points, including the formation of a transitional government with a specific mandate and setting a date for elections."
Egypt will now call a meeting of all Palestinian factions to sign a reconciliation agreement in Cairo, the agency added.
Palestinian Prime Minister Salam Fayyad welcomed the agreement, which came after 18 months of fruitless talks.
Israel`s Prime Minister Benjamin Netanyahu reacted angrily, demanding that Abbas "choose between peace with Israel or peace with Hamas."
Netanyahu said such an agreement paved the way for Hamas to take control of the West Bank too, where Palestinian Authority has its headquarters.
"The Palestinian Authority must choose between peace with Israel or peace with Hamas. There cannot be peace with both because Hamas strives to destroy the state of Israel and says so openly," the Israeli Premier said.
"I think that the very idea of reconciliation shows the weakness of the Palestinian Authority and creates the prospect that Hamas could retake control of Judea and Samaria just like it took control of the Gaza Strip," he said, referring to the West Bank.
Israeli Foreign Minister Avigdor Lieberman and Defence Minister Ehud Barak both said that the Jewish state would never accept a Hamas government.
"With this accord, a red line has been crossed," Lieberman said.
Palestinian Authority (PA) President Mahmoud Abbas` Fatah party`s chief delegate, Azzam Al-Ahmad, confirmed the report of agreement, saying the two sides had agreed to set up a "government of independents."
"This government will be tasked with preparing for Presidential and legislative elections within a year," Al-Ahmad said.
"The agreement is the beginning and we shall take quick steps to end the occupation and establish an independent Palestinian state," he stressed.
The Fatah leader accused Israel of using the division to "shirk its international responsibilities" and added that the US also abandoned its responsibility for ending "the longest occupation in history."
"We as Palestinians have learned a hard lesson for the past three years in our struggle against the occupation. The occupation exploited the division to Judaise Jerusalem, complete the fence and seize lands in the West Bank," al-Ahmed said adding, "We felt a need to end the division to end the occupation."
Hamas` deputy politburo chief, Moussa Abu Marzouk, announced during a press conference of the coming of a "new age" and said that all Palestinian factions will meet over the weekend to sign the agreement.
"This is not the end of the dialogue. After all the factions sign the understandings with Fatah and Hamas we shall form a new government and embark on a new era in the Palestinian struggle ? in order to obtain our rights and preserve the Palestinian people`s national rights," Marzouk added.
Mahmoud al-Zahar, a senior Hamas leader who participated in the talks, said that peace with Israel or recognition of the Jewish state, a key Quartet demand, was not on the table.
"Our programme does not include negotiations with Israel or recognising it," Zahhar said in Cairo.
"It will not be possible for the interim national government to participate or bet on or work on the peace process with Israel," he added.
A close aide to Abbas, Nabil Abu Rudeina, dismissed Netanyahu`s remarks.
"In reaction to Netanyahu`s remarks we say that Palestinian reconciliation and the agreement reached today in Cairo is an internal Palestinian affair," Nabil Abu Rudeina said.
Israel, he said, "must choose between peace and settlements."
"The agreement strengthens Palestinian unity and its just struggle to establish an independent state with Jerusalem as its capital," Abu Rudeina asserted.
Islamist Hamas and Fatah have fought bitterly since the former vanquished forces loyal to PA, mainly comprising of the latter`s activists, in pitched battles on the streets of Gaza in June 2007.
The Islamist faction has since been in control of the coastal Strip braving political and economic sanctions from Israel and the West alike.
The PA, led by Abbas and Fatah, meanwhile maintained control over the West Bank with Israel`s and West`s support but efforts to renew peace talks between the two sides have collapsed on the key issue of building settlements by Israel in the West Bank and east Jerusalem.
The PA has been threatening to ask the United Nations General Assembly to recognise an independent Palestinian state in 1967 borders if the deadlock in peace talks continue till September.