THE unthinkable is taking place today in Madrid. Arabs and Jews are sitting down together to talk about peace.Decades of animosity, armed hostilities, occupation, and bitter recriminations are yielding at least temporarily to a search for openings in a wall of rigid positions. The Bush administration's impossible dream has become reality in the land of Don Quixote. It is happening because the peoples of the region are weary of war, and their leaders know it, and because the end of the cold war and the outcome of the Gulf war have given a US administration a chance to grasp one of history's rare opportune moments. But this week's events will be seen as momentous only if the negotiators in Spain's royal palace demonstrate that these sessions signal the beginning of the end of two other impossible dreams. The Arab-Israeli conflict has proved intractable because key elements of both sides have clung to notions of nationhood that cannot be effectively realized. Since the creation of Israel in 1948, millions of Arabs have refused - and hard-liners still refuse - to accept the two-state solution for historical Palestine. In 1947, the United Nations approved a plan for partition that would have given the Palestinians more land for a state than they could now get if all the occupied territories were returned to them. The rejection of this plan in favor of an all-out struggle to eliminate Israel and return Palestinian exiles to their original homes has left hundreds of thousands stranded in overcrowded refugee camps or settled precariously, if more comfortably, in other people's lands. On the other side, Israel's Zionist founders sought a home for persecuted Jews and were willing to settle for the two-state UN plan. They aimed for a democratic, socialist nation that might serve as a model for regional development. In the caldron of the area's hostilities and ambitions, however, those goals have lost their shape and melted into an absolutist stance on a single-state solution - Greater Israel - that could recreate the error made by their adversaries decades ago. For Israel - militarily mighty, with wealthy friends and greatly weakened enemies - holding on to all the territory might seem a feasible goal, one clearly within reach. But it promises heightened regional bitterness and instability - grim prospects for a dependent nation, ailing economically. Arabs and Jews are at the peace table because they sense this is the last opportunity to salvage the situation. All have something to gain: Israel, the long-sought peace with Arab states, including guarantees of security; Syria, return of the Golan Heights and access to Western aid and technology; Lebanon, withdrawal of Israel from its southern region; Jordan, greater stability and the basis for resolving water and other regional problems; the Palestinians, a form of self-government and the prospect of n ational self-determination. All will start by presenting their grievances and demands for justice, based on their own sense of national interests. Whether they proceed to the next stage of genuine probing for ways to bridge differences depends upon their political will to find a solution and their courage in turning from impossible dreams that keep the enmities burning. All peoples have dreams. They can be an inspiring force for unity or, sometimes, for self-delusion and tragedy. Leaders with vision can shape effective policies that draw on dreams while taking present reality and long-term consequences into account. Anwar Sadat did that. The times are different, but the global atmosphere is even more conducive. The US will do its best: first, to help the delegations move successfully to the second, bilateral phase of the talks, and then to find formulas that will offer everyone some genuine sense of gain. But whether James Baker's efforts result in more than tilting at windmills depends squarely on the regional leaders themselves, who have always held the key to shaping their peoples' aspirations and leading in directions that secure their futures. It's time to reshape dreams that lead to conflict and despair.