Outside actors have essentially forced Israel's hand. President Obama called for a settlement freeze extension in his speech at the UN this week. Palestinian President Abbas has said that he will walk out of talks unless the freeze is extended. There can be little doubt on the positions of the two leaders, nor who will be blamed if a refusal to extend the freeze causes talks to fail.
Netanyahu's options are limited. On the one hand, if he extends the freeze he will face opposition at home. On the other hand, if he ends the freeze, he will face consequences from the United States and international community, and will take a legacy of failing to secure peace because of what the Israeli right seems to agree is a largely trivial issue.
Given the circumstances, Netanyahu can:
1) Stall for time. He can talk about the freeze as a matter of ongoing negotiation. Building has occurred in settlements during the freeze, and activists plan to build regardless of the policy of the Israeli state. Netanyahu proved he can win the "long game" by fending off President Obama last year. He could conceivably do it again.
2) End the freeze. This would appease the right and secure Netanyahu's base for a little while longer. It would demonstrate that Israel will not pay any price for peace. However, it would entail handing the United States a crisis, something Netanyahu has no interest in doing. It would also serve to appease the far right only for a short period of time. Even just participation in the talks has made the far right suspicious. While Netanyahu could stand on principle, it is unlikely he will all-out end the freeze.
3) Extend the freeze. This would put the US and the international community at ease and would shift the burden of concession much more to the Palestinians. Israel can always cancel the freeze so its not a permanent concession. While it may cause a vote of no confidence from within his coalition, Netanyahu has already taken that risk by entering peace talks in the first place. And he would likely survive new elections or an attempt to align with Kadima. The negotiations would stay on track and Netanyahu would reap the benefits in US-mediated negotiations for taking a decisive stance for peace.
However, from Netanyahu's perspective, what he should actually do is:
4) Announce an extension of the freeze while permitting some building. It will be enough building to keep the settlers at bay but not so much that the US will be forced to call Israel out on it. It's also the option closest to the status quo, as some building has continued despite the announced freeze. Netanyahu will need to stall a little on announcing this so as not to look like he is conceding to Palestinian demands. Yet the "half and half" option is the best way for Netanyahu to balance between all the constraints being placed on him.
We'll see what happens tomorrow. Netanyahu is a smart politician, and is likely to make a decision which serves his interests. But the only thing truly reliable in Middle East politics is that there will always be surprises.