But they are illegal! At least from this perspective:
The settlements are officially military occupations - Israel has not annexed them, but clearly there is not a palestinian sovereign governing the region. And it is also clear that the Israelis have to be the occupiers. I am not sure if there is any other possible designation to be given to the situation, but I find its official designation by the UN to be quite agreeable.
I think the Israeli perspective is that the territories were acquired under an aggressive war by the Arab countries, but they still haven't /acquired/ them. So the Palestinians are not covered by Israeli government services, Israeli rights, so on. They aren't citizens, they're nobodies really - no state to look after them.
Anyways, it is illegal for the Occupying power to "deport or transfer parts of its own civilian population into the territory it occupies", by the Fourth Geneva Convention. We can debate the point of Art. 49, but it sure sounds like a prevention of colonization - a sort of a cheap shot in which you gradually make a territory your own, but don't have to provide all of the goodies that you give to the rest of your citizens. Actually I think population transfers would screw up negotiations as well, because being occupied territories, they technically belong to someone else - except after the settlements, they don't really have a say as the territories are now increasingly populated with the Occupying power's own people. Considering what is going on in the West Bank and other territories, I feel it is very difficult to argue against the spirit of article 49, even if you debate technicalities like interpreting that the Israeli government isn't physically placing people into settlements.
Other international law documents have similar articles, except they may or may not be ratified by Israel meaning that they aren't bound by them. On the subject of binding, a lot of these UN rulings are nonbinding, and so they don't translate into real-world action. So while the settlements may look justified because nobody's doing anything against them, nobody is bound to do anything against them and nobody wants to mess with Israel, whether as a friend or enemy.
I think Israel is past the whole Holocaust issue. While that may have been the main force in its founding, I interpret the national identity of Israel to be more "Israeli" than "Jewish". Which to me means more self-identification of being Middle-eastern, being in opposition to Arabs, versus the shining beacon of Judaism in and of itself - one good example is how they're not treating Ethiopians as their own, even though a lot of Ethiopians have been pretty darn Jewish for hundreds if not over a thousand years.
As an aside, it is very interesting to read these opinions as a Canadian (I'm assuming most of you are Americans

). Israeli news isn't really a mainstream thing over here, neither in the media nor public discourse, so you have to do a lot of the searching yourself - meaning going from CNN to Haaretz to international law documents to al Jazeera XD