By Michael Stott and Crispian Balmer
JERUSALEM, May 9 (Reuters) - World powers must not yield in their demand Iran abandon sensitive nuclear projects, a senior Israeli official said on Wednesday, arguing Tehran had been allowed to "dictate" terms despite being vulnerable to sanctions.
Speaking a day after Israel formed a surprise unity government fuelling speculation that preemptive war on Iran could be in the works, Deputy Foreign Minister Danny Ayalon voiced cautious hope for a peaceful resolution from international talks with Tehran due to resume on May 23.
"We would very much like the negotiations to succeed, because a political solution is better than any other option," he said. "At the same time, a bad deal would be worse than no deal."
Talks between Iran and the five U.N. Security Council permanent members plus Germany resumed last month, more than a year after they collapsed with powers failing to persuade Tehran to abandon uranium enrichment. The next round of talks is expected to take place later this month in Baghdad.
The United States and European Union have imposed tough new sanctions on Iran's oil exports this year, and say they hope this can force Tehran to make a deal to curb a nuclear programme they believe aims to make an atomic bomb.
Israel says it could attack Iran if it thinks that is the only way to stop it from getting nuclear arms. Washington and Brussels have been urging Israel not to launch any strikes until diplomacy has a chance, but Israeli officials say time is short.
Like Israel, the powers have insisted that an eventual accord require Iran to suspend uranium enrichment. But the Los Angeles Times said last month Washington might agree to allow Iran to continue processing uranium to 5 percent fissile purity.
If enriched further, uranium can be used to fuel warheads. Iran says it has no military designs and seeks only nuclear energy and medical isotopes. It says it will never agree to curbs on its uranium enrichment.
"The fact we hear some rumours about compromise, about meeting them halfway here and there, I think is very, very dangerous," Ayalon told Reuters in a small conference room in Israel's parliament that, to double as a wartime shelter, had been fitted with an industrial air filter and blast-proof walls.
Allowing Iran to keep enriching and stockpiling uranium could enable Tehran to opt for a bomb "in very short order", he said, adding that those projects were already "accelerating".
Israel's Iran timelines have often been more urgent than those of its Western allies. But with Prime Minister Benjamin Netanyahu now saying the Iranians are just months away from fortifying their nuclear sites against air strikes, fears of an imminent new Middle East conflict have surged abroad.
Netanyahu's alliance with centrist opposition leader Shaul Mofaz on Tuesday appeared to buttress Israel further for war. Yet Iran strategy did not feature in the two leaders' coalition negotiations, a senior official told Reuters, adding that Israel potentially had until 2013 to decide how to tackle its arch-foe.
In Israel a day after Netanyahu dropped his political bombshell, Catherine Ashton, the EU foreign affairs chief and senior liaison for the six world powers in talks with Tehran, briefed the prime minister about the nuclear negotiations.
Mofaz, Defence Minister Ehud Barak and Foreign Minister Avigdor Lieberman also attended the session. An Israeli official said the Israeli leaders told Ashton it was clear Iran has been using the talks to play for time and there was no evidence it intends to stop its pursuit of a nuclear weapon.
Ayalon, a former ambassador to Washington who belongs to Lieberman's ultra-nationalist Yisrael Beitenu party in Netanyahu's government, declined to be drawn on whether Israel might defy the misgivings of the United States and other powers by attacking Iran unilaterally.
"I don't want to lock ourselves to anything," he said, adding: "Certainly we are not a part to any of these agreements (between world powers and Iran) and I think we have all the rights to be concerned based on the threats coming from Tehran."
Iran "can be stopped" if subjected to more aggressive diplomacy, including sanctions on its oil and banks, Ayalon said.
"Of course there is a bad taste in that they dictate(d) the venue," he said, referring to discussion over Baghdad hosting this month's talks after the first, April 14 round in Istanbul. "That's not something we should all be proud of. We don't think Iran is in a position to negotiate at all."
He cited U.S. findings that the Iranians lost $60 billion since July due to tightening sanctions, and noted their decision to back down after a bout of naval brinkmanship with the U.S. Navy in the strategic Strait of Hormuz in December and January.
"If its oil exports are reduced by only 40 percent ... then their economy is ground to a halt and things will evolve very radically from there," Ayalon said.
"There is a lot of spin and a lot of psychological warfare, but Iran is a very vulnerable country ... We do know that the ayatollahs, as fanatic and dangerous as they are, are not irrational when it comes to their own political survival."
Israel itself is widely presumed to have a nuclear arsenal, which it neither confirms nor denies. Unlike Iran, it has never signed up to the non-proliferation treaty that requires it to forego nuclear arms in return for guaranteed access to peaceful nuclear technology.
Asked if Israel might resign itself to containing a nuclear Iran, Ayalon said: "This is a bridge not yet built, let alone crossed." (Writing by Dan Williams; Editing by Peter Graff)