Israel cannot have both, John Kerry said in unprecedented comments at the annual Saban Forum hosted by the Brookings Institution in Washington DC.
"There is no status quo. It is getting worse," said Kerry, referring to the Israeli-Palestinian conflict. "It is moving in the wrong direction."
Kerry, who described himself as an "unapologetic friend of Israel", said Tel Aviv is nonetheless "ignoring all our warnings regarding settlements".
"There is a basic choice that has to be made by Israelis, by the leadership of Israel," he said, "and that is are there going to be continued settlements, is there going to be a continued implementation of settlement policy, or is there going to be separation and the creation of two states?"
Still, the top diplomat said the "tipping point" between the alternatives had not yet been crossed.
The comments are some of the sternest to date from the U.S., Israel's staunchest ally on the international stage.