"Jerusalem is not a settlement, it's our capital," he said in Washington.
But Mr Netanyahu did not mention the approval of plans to expand the East Jerusalem settlement of Ramat Shlomo in his speech to a pro-Israel lobby group.
Earlier, US Secretary of State Hillary Clinton told the meeting Israel had to make "difficult" choices for peace.
She said the continued expansion of Jewish settlements in Palestinian occupied territory undermined the US role in the peace process.
The Palestinian Authority is furious at Israel's insistence on building on occupied territory. It sees it as a serious stumbling block to the resumption of talks, which have been stalled for more than a year.
Some 500,000 Jews live in more than 100 settlements built since Israel's 1967 occupation of the West Bank and East Jerusalem. They are considered illegal under international law, which Israel disputes.
Call to Abbas
In his speech to a convention of the influential American Israel Public Affairs Committee (Aipac) on Monday evening, Mr Netanyahu said that "the Jewish people were building Jerusalem 3,000 years ago and the Jewish people are building it today".
Settlements in occupied East Jerusalem were an "inextricable" part of the city, he said, and would remain part of Israel under any peace agreement.
"Therefore, building in them in no way precludes the possibility of a two-state solution."
He said Israel wanted Palestinians to be "our neighbours, living freely" and called on Palestinian Authority President Mahmoud Abbas to "come and negotiate peace".
Mr Netanyahu added that while the US could help resolve both sides' problems, peace could not be imposed from the outside.
Speaking just hours earlier to the same audience, Mrs Clinton urged Mr Netanyahu to extend Israel's suspension of new building in the West Bank to include East Jerusalem.
She said the continued expansion of Jewish settlements undermined "mutual trust and endangers the proximity talks that are the first step toward the full negotiations that both sides want and need".
"It exposes daylight between Israel and the United States that others in the region hope to exploit," she added.
Last week, the Israeli prime minister proposed a series of "trust-building measures" that he said represented "a real effort" to aid US peace efforts.
Although details have not yet been made public, Israeli officials said these included an agreement to discuss all outstanding issues in the indirect "proximity talks" being mediated by US special envoy George Mitchell.
In Monday's speech, Mr Netanyahu also warned that "Iran's brazen bid to develop nuclear weapons... is the threat to the entire world".
He urged the world community to act "swiftly" to "swart this danger".
Iran insists its nuclear programme is solely for civilian purposes.
