Trump made the statement during the annual United Nations General Assembly on Wednesday after meeting Israeli Prime Minister Benjamin Netanyahu. He said a two-state solution could resolve the decades-old Palestinian-Israeli conflict.
It was the first time since taking office that Trump endorsed a two-state solution as the best way to resolve the conflict.
Husam Zomlot, head of the recently closed Palestinian mission in Washington, DC, denounced the US president's comments.
"Their words go against their actions and their action is absolutely clear [and] is destroying the possibility of the two-state solution," Zumlot said.
'Works the best'
Trump also said he wanted to unveil details of what he has long referred to as the "deal of the century" to resolve the Israeli-Palestinian conflict in the next two to three months.
According to reports, the proposal prohibits the return of more than five million Palestinian refugees and removes the status of Jerusalem from negotiations.
"I like a two-state solution. That's what I think works best. That's my feeling," said Trump.
Netanyahu said after meeting Trump he was "not surprised" at the US president's preference for a two-state solution for peace, Israeli media reports said.
Last week, the US announced it was shutting down the Palestine Liberation Organization's (PLO) diplomatic office in Washington over the Palestinian Authority's refusal to enter into US-brokered negotiations with Israel.
The move came amid deteriorating ties between the two sides in the wake of Trump's controversial recognition of Jerusalem as Israel's capital late last year and the relocation of its embassy there.
'Toughest of all deals'
"I really believe something will happen. They say it's the toughest of all deals," Trump said of attaining peace between the two sides.
"It is a dream of mine to get that done prior to the end of my first term ... I think a lot of progress has been made. I think that Israel wants to do something and I think that the Palestinians actually want to do something."
The Palestinian leadership, which sees East Jerusalem as the capital of a future state, suspended contacts with the US after it recognised Jerusalem as the capital of Israel.
The Palestinians insist the status of the city is an issue to be negotiated between them and the Israelis.
In the past, Trump dropped the long-standing commitment to a two-state solution, saying he would back a single-state solution after a meeting with Netanyahu in February 2017. He later walked that back saying he would support a two-state solution if both sides agreed to it.
1967 borders
Nabil Abu Rudeineh, a spokesman for Palestinian Authority President Mahmud Abbas, told reporters in the occupied West Bank city of Ramallah that Trump needs to act on his statement.
"In response to what Trump said about the two-state solution, the two-state solution means to us that we have a Palestinian state on the 1967 borders, with East Jerusalem as its capital," Abu Rudeineh said. "This is the only way to achieve peace."
He added Palestinians want to resolve all core issues of the conflict - which include borders, illegal settlements, refugees, security and the status of Jerusalem - "according to United Nations resolutions".
Abbas will speak at the UN General Assembly on Thursday.
Trump said the embassy move to Jerusalem would actually help peace efforts, saying Israel would now have to make concessions to the Palestinians in any negotiations.
"Israel got the first chip and it's a big one. By taking off the table the embassy moving to Jerusalem, that was always the primary ingredient as to why deals couldn't get done," said Trump.
"Now, that's off the table. Now, that will also mean that Israel will have to do something that is good for the other side."
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