Kerry's speech on Wednesday comes days after the US refused to veto a United Nations Security Council resolution that called Israeli settlements in the West Bank and east Jerusalem a violation of international law.
Israeli Prime Minister Benjamin Netanyahu has slammed the resolution and accused the US of colluding with the Palestinians in drawing it up.
Kerry rejected criticism that the vote abandons Israel. He said it's Israel's policy allowing permanent construction of settlements in the West Bank and east Jerusalem that risks isolating Israel from other nations.
Kerry also said the United States "did not draft or originate" the UN resolution condemning the settlements, "nor did we put it forward" in the UN.
US Secretary of State John Kerry. Source: AAP
Expanding Israeli settlements in the West Bank and east Jerusalem are leading to an "irreversible one-state reality", despite polls showing that most Israelis support the creation of a separate Palestinian state.
Kerry also said people in Israel are unaware how systematic the settlement process has become in recent years, with tens of thousands of Israelis moving into the middle of Palestinian territories.
Kerry outlined a series of principles he says could form the basis of a future peace accord and that there must be a two-state solution that includes a "secure and recognised border".
An agreement must help Palestinian refugees, designate Jerusalem as a capital for both states and satisfy Israel's security needs, Kerry said.
The top US diplomat is leaving office next month along with President Barack Obama.
Kerry said if Israel rejects a two-state solution for peace with the Palestinian people, "it can be Jewish or it can be democratic".
A senior Israeli Cabinet minister, Gilad Erdan, called Kerry's speech a "pathetic step," further heightening tensions between the two close allies as Obama prepares to leave office.
Israeli leaders have made no secret they are counting on President-elect Donald Trump to change US policy.
A prominent Israeli opposition politician has given a warm reception to John Kerry's Mideast policy speech.
Yaakov Peri, a former chief of Israel's Shin Bet security agency, praised what he called Kerry's "balanced speech, based on reality and facts".
Peri says the secretary of state drew attention to the "harsh and dramatic consequences" of a single bi-national state.
Peri is a member of the centrist Yesh Atid party, which sits in the opposition. But his words carry significant weight given his experience battling Palestinian militants.
MORE NEWS ABOUT THE UN RESOLUTION
Israel pressing ahead with settlements after UN vote
Trump urges Israel to 'stay strong'
US President-elect Donald Trump has chided the Obama administration for its stance toward Israel, shortly before the US secretary of state was set to deliver a speech regarding international opposition to Israeli settlement building.
"We cannot continue to let Israel be treated with such total disdain and disrespect. They used to have a great friend in the U.S., but.......," Trump, a Republican, wrote on Twitter on Wednesday.
"not anymore. The beginning of the end was the horrible Iran deal, and now this (U.N.)! Stay strong Israel, January 20th is fast approaching!" he added, referring to when he takes over the White House from Democratic President Barack Obama.
