By Dan Williams

JERUSALEM (Reuters) -Israel ruled out on Sunday any eventual physical mission in Jerusalem for the first Saudi envoy to the Palestinians, even as they cast his appointment as endorsement of their goal of a state that would include part of the city as its capital.

Saudi Ambassador to Jordan Nayef Al-Sudairi on Saturday expanded his credentials to include non-resident envoy to the Palestinians. A social media post by his embassy said "consul-general in Jerusalem" was also now among Al-Sudairi's duties.

The move came after Washington said there had been some progress in its efforts to mediate a forging of formal relations between Israel and Saudi Arabia - which had previously ruled out such a pact until Palestinian statehood goals are addressed.

Signalling that they felt sidelined by the stepped-up indirect talks, the Palestinians voiced hope earlier this month that Riyadh would hear their concerns and coordinate with them.

They sounded more upbeat after Al-Sudairi's appointment.

"What does it mean to also say (he is) 'consul-general in Jerusalem'? It means a continuation of the positions of Saudi Arabia," Palestinian Ambassador to Riyadh Bassam Al-Agha said.

Interviewed on Voice of Palestine radio, Al-Agha further interpreted the appointment as a "rejection" of the U.S. recognition in 2017 of Jerusalem as Israel's capital.

The Palestinians want a state in territories captured by Israel in a 1967 war, with East Jerusalem as their capital. U.S.-sponsored negotiations with Israel on achieving that stalled more than a decade ago.

Among the hurdles have been Israeli settlement of occupied land and feuding between Western-backed Palestinian authorities and armed Hamas Islamists who spurn coexistence with Israel.

Another sticking point is Jerusalem, which Israel deems its indivisible capital - a status not widely recognised abroad. Israeli authorities bar Palestinian diplomacy in the city.

Al-Sudairi presented his credentials to the Palestinian mission in Amman, indicating the Jordanian capital would remain his base.

"This (Al-Sudairi) could be a delegate who will meet with representatives in the Palestinian Authority," Israeli Foreign Minister Eli Cohen told Tel Aviv radio station 103 FM.

"Will there be an official physically sitting in Jerusalem? This we will not allow."

Israel's hard-right government has played down any prospect of it giving significant ground to the Palestinians as part of the potential normalisation deal with Saudi Arabia.

"What is behind this development (Al-Sudairi's appointment) is that, against the backdrop of progress in the U.S. talks with Saudi Arabia and Israel, the Saudis want to relay a message to the Palestinians that they have not forgotten them," Cohen said.

(Additional reporting by Nidal al-MughrabiWriting by Dan WilliamsEditing by Bernadette Baum and Frances Kerry)