You're absolutely right about the status of the Palestinians. But the Palestinians were never given Israeli citizenship (and now they vote for their own government BTW). Still, I won't argue with anyone saying that their status is in the shits - that's a given.
However, this is besides the point. The argument against Israel here is that it's based on religion and therefore makes non-Jews 2nd class citizens purposely - which is simply not true. There are Israeli citizens who are Arabs, Muslims, Christian and so on and they enjoy the same liberties and opportunities as Jewish Israelis. The status of the Palestinians has aboslutely nothing to do with the fact that Israel is defined as a Jewsih state. It has everything to do with the fact that we are and have been in a violent conflict with them for the past 100 years.
My point is that there is nothing wrong with Israel being a Liberal democracy and a Jewish state - it *can* work, and the status of the Arab Israelis and all other minorities and religions in Israel is proof of that.
RE your comment about neighborhoods again separate the Palestinians from Arab Israelis - any Israeli Citizen can live anywhere they want. In fact there was a case that made the headlines a couple of years back of an Arab family that wanted to live in a Kibutz and were rejected - the high court then overruled the Kibutz's decision and forced it to accept them. I remind you that Kibutzes have entry criteria that all would-be members must comply with (they are basically socialist villages). The situation with the Palestinans is of course different and they can't live outside the territories, but goes back to the my point above. Furthermore, Jewish Israelis can't in practice live in Israeli Arab villages or in most of the Palestinians territories anyway.
The bottom line is that there is nothing wrong with the way Israel is defined, or inherently because of it. The problems are all the result of the circumstances, practicalities, the tensions between the different groups in question, etc. When we finally have peace in this corner of the world one day all of these problems will go away and we'll just have a liberal western democracy with a Jewish theme.