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In the courtyard of Yasser Arafat's battered Ramallah compound, a few hundred Palestinians newly released from Israel's jails gathered last Thursday lunchtime with their families. The Palestinian leader emerged smiling from a meeting with Archbishop of Canterbury Rowan Williams to greet the crowds. Arafat puckered his lips and blew kisses, no doubt expecting the kind of drawn-out session of mass adulation he relishes. But the prisoners knew whom to thank for their freedom. "Long live Hizballah!" they chanted. "Long live Hassan Nasrallah!" The name of the Lebanese Muslim fundamentalist militia leader wiped the smile off Arafat's lips: he immediately turned around and rushed into his office.

For Arafat, last week's swap of Palestinian and other Arab prisoners for a kidnapped Israeli businessman and the bodies of three Israeli soldiers represents a real problem. The three-year intifadeh has left a power vacuum in the West Bank and Gaza that Hizballah, the Beirut-based, Iranian-backed Shi'ite group, has gradually been filling. The prisoner swap, mediated by Germany, boosts Hizballah's support among Palestinians and illustrates the ineffectuality of Arafat's regime, which has fruitlessly demanded that Israel release Palestinian detainees. "Arafat is scared to death because of what happened between Hizballah and Israel," says a senior Palestinian security official. "The prisoner deal makes him look like a dwarf."

The prisoner deal came after German mediator Ernst Uhrlau, the coordinator of his country's Federal Intelligence Service, persuaded Iran to pressure Hizballah to strike a bargain. The agreement is split into three stages. In last week's swap, Israel freed 429 prisoners and detainees and returned the bodies of 60 Lebanese killed as far back as 1984; in return, Israel received the corpses of three soldiers killed on the Lebanese border in October 2000. Hizballah also released Elhanan Tennenbaum, an Israeli businessman it had kidnapped in 2000. Israeli security officials believe Tennenbaum went to Lebanon to sell medicines that were past their expiration date; he says he was on a private mission to locate an Israeli airman shot down over Lebanon in 1986.

The fate of that airman, Captain Ron Arad, is part of the second stage of the prisoner deal. Israeli intelligence officials believe he is dead. Some of the Lebanese prisoners released last week were captured by Israel as bargaining chips for Arad or his remains. The fact that they've been freed is a signal that he will figure in the deal. Hizballah is expected to give Israel information on Arad in return for Samir Quntar, imprisoned in Israel since he stole across the border in 1979 and killed a policeman and three members of an Israeli family. Israeli officials are hopeful that the third stage of the deal will see the return of Arad's body by the end of spring.

The prisoner swap is controversial in Israel, where many believe the freed Palestinians will commit terror attacks again. People close to Batya Arad, the missing airman's mother, say that before she died in June 2002 she told her family she didn't believe Palestinian terrorists should be exchanged for her son's body. Ministers in Prime Minister Ariel Sharon's cabinet criticized him for dealing with Hizballah's Nasrallah, saying it would invite Palestinians to kidnap Israelis in the West Bank to bargain for another prisoner release. Those criticisms intensified after Hamas announced it would begin a kidnapping program and another suicide bomber struck on a Jerusalem bus outside Sharon's residence Thursday, killing at least 10 Israelis — the deadliest attack in almost four months. Sharon defended his deal and condemned the bombing at a ceremony to mark the return of the three soldiers' bodies. "This is the price a society that sanctifies the value of life has to pay for living side by side with a society that does not lift a finger to root out the murder and evil from its midst," Sharon said.

Soon after he spoke, Sharon sent the Israeli army into Bethlehem, where the bus bomber had lived. Army sources say they arrested five men connected with the attack. But the political fallout of the prisoner swap could keep Israel's military busy in the weeks ahead. The bus attack was carried out by a member of the Aqsa Martyrs Brigades, a subgroup of Arafat's Fatah. Fatah militiamen told TIME they felt pressure to act against Israel to show the Palestinian public they were just as effective in their struggle against Israel as Hizballah.

• MATT REES | Jerusalem
• Germany brokers a prisoner swap between Israel and Hizballah. Arafat's frozen out — but the killing goes on