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Israel and Turkey have reached an understanding that could lead to the restoration of ties between the two former allies, an Israeli official said Thursday.

Relations between the two countries broke down in 2010 after an Israeli naval raid on a Gaza-bound flotilla that killed eight Turkish citizens and one Turkish-American.

The flotilla had intended to break the Israeli blockade on Gaza imposed since 2007.

In the aftermath of the raid, Turkey became one of the strongest critics of Israeli actions in Gaza.

Salah al-Arouri, a Turkey-based leader of Hamas, will also be banned from operating in Turkey according to the Israeli source.

Israel apologised to Turkey for the deaths and agreed to compensate the victims' families under a US-brokered arrangement in 2013.

However efforts to restore ties faltered amid a renewed Israeli aggression against Gaza in the summer of 2014 that killed at least 1483 Palestinian civilians according to the UN.

The Israeli official, who spoke on condition of anonymity because he wasn't authorised to speak to the media about the diplomatic talks, said the sides agreed that Israel would compensate the families of the flotilla victims.

The official said Turkey would waive legal claims against Israel over the raid and that the countries would upgrade diplomatic ties by returning ambassadors.

Salah al-Arouri, a Turkey-based leader of Hamas, will also be banned from operating in Turkey according to the Israeli source.

A US official familiar with the agreement confirmed the details. He also spoke on condition of anonymity because he wasn't allowed to talk to the media about the subject.

The Israeli official said the understanding requires final approval, adding that it was achieved between the incoming head of Israel's Mossad Yossi Cohen and the Turkish Foreign Affairs Undersecretary Feridun Sinirlioglu.

The official also said talks to lay down a natural gas pipeline from Israel to Turkey would begin soon.

Earlier this week, Turkish President Recep Tayyip Erdogan signaled a possible warming of relations with Israel, saying in published comments that the entire region would benefit from the normalisation of ties.