I want to take this out of the context of the Israeli-Palestinian dispute and suggest that it is a great idea in general. I live in teachers-occupied territory. That is, the teachers' union governs Montgomery County, Maryland. I would like to have a different sovereign, but without having to move. Under virtual federalism (as proposed in the widely-unread Unchecked and Unbalanced), we would unbundle the services that the County provides. I could then contract with another provider for trash collection, snow removal, fire protection, or other services.
Land-use regulation could primarily be handled at a neighborhood level. Roads could be privately owned and maintained, with electronic toll collection. (Not every trip need involve a toll. I might be able to buy a monthly pass at a flat rate that covers any trip other than during congested times.)
Concerning Tyler's point about dispute resolution, I think there would have to be courts that would resolve jurisdictional issues. Thus, there would have to be a court or similar body to handle land-use issues that cut across neighborhoods. Taxes would only be used to support such courts. Otherwise, public goods and services would be supported by user fees, membership fees, and donations.
Over the last year or so, Arnold has become my favorite econblogger.