Here is what I see...
Iraq sends two scuds at Israel with chemicals, kills a few thousand. The IDF nukes Baghdad kills millions. Then the unthinkable occurs. (Are you ready for this one?)
Saddam Hussein demands that Israel surrenders or faces countless scuds over the following days.
Sharon realizes that there is no way to defeat a mad man that cares nothing for millions of his own and surrenders rather than face more Israeli casualties.
Sharon agrees to specific terms, which includes America must withdraw from the region, leaving Israel standing alone, and Israel is de facto ruled over by Saddam.
It could happen. We are talking about Saddam here. Since you cannot find and destroy each of his scud missiles, you cannot win against him short of a massive, sudden nuclear strike all across the Iraqi frontier. Then you get into genocide, and stuff like that is very difficult to justify.
Secondly, The U.S. would never allow it to happen in the first place. We could take out most of their Scuds in a few hours, and our Patriot ABM technology is considerably more advanced than it was a decade ago. With several batteries of Patriots devoted to each Scud, I'd be very suprised if even one of them made it to its target.
You're absolutely right about Saddam being a madman and caring not a whit for his people, but I think you're severely underestimating the military prowess and sophistication of both Israel and the U.S. ...And the idea of Sharon surrendering to Saddam is downright laughable.