Vatican City is indeed an independent State; but it is fully surrounded by the city of Rome completely within the State of Italy. As a result, Roman and Italian authorities have a great deal of control of the facts on the ground. Having an independent City-State of Jerusalem on the fault-line between two countries who have been bitterly disputing where that boarder should be for year, seems like a recipe for disaster, especially considering the history of armed militant factions that currently operate within Palestinian areas.
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Firebomb explodes near gas station in East Jerusalem; no injuries or damage caused (Haaretz)
from the article: Would East Jerusalem Arabs rather be citizens of Israel or Palestine?