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Israeli Prime Minister Yitzhak Rabin and King Hussein of Jordan formally made peace at a ceremony in desert area of Wadi Araba on the Israeli-Jordanian border.
US President Bill Clinton was a witness to the treaty also watched by 5,000 guests and relayed to the world on TV.
Palestinian leader Yasser Arafat was conspicuous by his absence - he had not been invited.
Jordan is now the second Arab state to establish close relations with Israel since Egypt made peace in 1979.
In an emotional speech King Hussein said: "This is peace with dignity. This is peace with commitment. This is our gift to our peoples and the generations to come."
Mr Rabin spoke of his joy at establishing peace among soldiers and friends.
He said: "'It is not only our states that are making peace with each other today, not only our nations that are shaking hands in peace here in the [Wadi Araba].
"You and I, your majesty, are making peace here, our own peace, the peace of soldiers and the peace of friends."
The president praised Mr Rabin and King Hussein for their efforts to end hostilities over recent years.
In a barely veiled attack on Islamic extremists, President Clinton said opponents of peace "who cloak themselves in the rhetoric of religion and nationalism" would not succeed.
All Israelis except the extreme right-wing welcome the agreement. The Israeli Knesset (parliament) ratified it by 105 to three.
Many Palestinians, who make up 60% of Jordan's population, are angered and shocked by the peace deal which they believe fails to address their grievances.
The Palestinian Liberation Organisation has condemned the role accorded to Jordan in protecting Islamic shrines in East Jerusalem.
In Jerusalem and throughout the occupied West Bank, Palestinians held a general strike and demonstrations.
In Hebron, they burned pictures of King Hussein and there were clashes with Israeli troops in Nablus.
Hamas, which just eight days ago carried out a devastating suicide bomb in Tel Aviv killing 22 people, has accused President Clinton of double-standards and vowed to continue its campaign of violence "anywhere in the world".
Under the agreement, Israel and Jordan agreed to exchange territory and make the border conform to geographical landmarks.
The treaty opens the way for co-operation in trade, tourism, transport links, water resources and environmental protection. It also secures the Israel's longest land border.
Yitzhak Rabin was assassinated on 4 November 1995 by a Jewish extremist and in 1999 King Hussein of Jordan died of cancer.
Shimon Peres pushed on with Mr Rabin's efforts to make peace with the Palestinians.
But in an election in 1996 he lost to Binyamin Netanyahu who campaigned against the Rabin-Peres peace programme.
But the peace deal struck by Israel and Jordan in 1994 lives on.
In September 2002, Jordan and Israel agreed on a plan to pipe water from the Red Sea to the shrinking Dead Sea that straddles the two countries.
The project, costing $800m, was the two nations' biggest joint venture to date.
And 18 months later, in March 2004, the two nations agreed a joint project to build a desert science centre on their shared border.
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