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Israeli prosecutors on Sunday agreed not to press murder charges against a settler suspected in a 2015 arson attack that killed a Palestinian toddler and his parents, the justice ministry said.

The fire bomb attack in the occupied West Bank village of Duma killed 18-month-old Ali Saad Dawabsha and fatally injured his mother and father.

His brother Ahmed, four at the time, was the sole survivor from the immediate family and escaped with severe burns.

The justice ministry said that in a plea deal, the accused - 17 at the time of the killings and on trial as a minor - had admitted to staking out the village ahead of the killings.

In a statement, it said the unidentified youth, together with adult defendant Amiram Ben-Uliel, had observed the village through binoculars and discussed possible arson targets.

The youth was charged in 2016 with being an accessory to committing a racially motivated murder.

Ben-Uliel, from the northern West Bank settlement of Shilo, remains on trial on three counts of murder and one of attempted murder, along with arson and conspiracy to commit a hate crime.

Sunday's statement said that the two had decided to raid Duma but the minor did not show up at the planned rendezvous and therefore did not take part in the murders.

"It was determined that the defendant committed a conspiracy to commit a crime motivated by a racist motive," it said.

It added that under the plea bargain, the prosecution would seek a sentence of five and a half years in prison, subject to a mandatory review by the probation service. 

The suspect has already spent two years in jail and a year under house arrest, Haaretz daily said Sunday.

An Israeli district court had ordered him transferred from prison after throwing out parts of his confession, which it ruled that investigators had obtained through physical coercion, described by defence lawyers as torture.

The attack drew renewed attention to Jewish extremism and sparked accusations Israel has not done enough to prevent such violence.

Prime Minister Benjamin Netanyahu labelled it "terrorism" - a word more usually used by Israelis to refer to violence committed by Palestinians.