* Kerry, Zarif in five-hour meeting to seek to narrow differences
* Iran wants oil, banking sanctions eased to launch deal
* Powers rule this out, offer Iran access to frozen assets
* Israel denounces budding deal, won't be bound by it
* US Congress threatens new sanctions, a risk to diplomacy
By Lesley Wroughton and Yeganeh Torbati
GENEVA, Nov 9 (Reuters) - Iran and six world powers extended high-stakes talks over Tehran's nuclear programme into an unscheduled third day on Saturday, as their top diplomats laboured to hammer out a long-sought deal to end a decade-old standoff.
The United States and Iran were cautious and tight-lipped after a five-hour trilateral meeting between their foreign ministers and European Union foreign policy chief Catherine Ashton, who is coordinating talks with the Islamic state for the six powers.
They were searching for an agreement to ease international fears that Iran is seeking the capability to make nuclear weapons and, in exchange, offer the Middle East nation limited relief from sanctions that are hurting its economy.
The aim is to take a first step towards resolving a protracted dispute that could otherwise plunge the volatile and oil-rich region into a new conflict.
"We're working hard," U.S. Secretary of State John Kerry told reporters as he arrived at his hotel shortly before midnight (2300 GMT) following the meeting with Ashton and Iranian Foreign Minister Mohammad Javad Zarif.
A senior State Department official said: "Over the course of the evening, we continued to make progress as we worked to the narrow the gaps. There is more work to do."
Iranian Deputy Foreign Minister Abbas Araqchi said: "It was productive but still we have lots of work to do."
The negotiations, originally planned as a two-day meeting for Thursday and Friday, will continue on Saturday morning.
Unlike previous encounters between Iran and Western powers in the past decade, all sides have remained quiet about details of the negotiations, without the criticism and mutual allegations of a lack of seriousness that were typical of such meetings in the past. Diplomats involved in the talks say this is a sign of how serious all sides are.
Midway through the second round of talks since Iran elected a moderate president who opened doors to a peaceful solution to the nuclear dispute, Kerry joined fellow big power foreign ministers in Geneva to help cement a preliminary accord. Israel warned they were making an epic mistake.
Kerry said he would try to "narrow these differences but I don't think anybody should mistake there are some important gaps that have to be closed."
Iran spelled out a major difference soon afterwards, with a member of its negotiating team, Majid Takt-Ravanchi, telling Mehr news agency that oil and banking sanctions imposed on Tehran should be eased during the first phase of any deal.
The powers have offered Iran access to up to $50 billion in Iranian funds frozen abroad for many years but ruled out any broad dilution of sanctions in the early going of an agreement.
Diplomats said a breakthrough remained uncertain and would in any case mark only the first step in a long, complex process towards a permanent resolution of international concerns that Iran may be seeking the means to build nuclear bombs.
ISRAEL "REJECTS" MOOTED IRAN DEAL
But the diplomats said the arrival of Kerry, British Foreign Secretary William Hague and French and German foreign ministers Laurent Fabius and Guido Westerwelle signalled that the five permanent U.N. Security Council members and Germany may be closer to an elusive pact with Iran than ever before.
Russian Foreign Minister Sergei Lavrov was expected to join them on Saturday. Lavrov's deputy was quoted by state-run RIA news agency as saying the sides were loath to leave Geneva "without a positive result (since to do so) would be a serious strategic mistake."
A senior U.S. State Department official said Kerry was committed to doing "anything he can" to overcome the chasm with Tehran. The powers aim to cap Iran's nuclear work to prevent any advance towards a nuclear weapons capability.
Kerry arrived from Tel Aviv, where he met Israeli Prime Minister Benjamin Netanyahu, who regards Iran's atomic aspirations as a menace to the Jewish state.
Netanyahu warned Kerry and his European counterparts that Iran would be getting "the deal of the century" if they carried out proposals to grant Tehran limited, temporary relief from sanctions in exchange for a partial suspension of, and pledge not to expand, its enrichment of uranium for nuclear fuel.
"Israel utterly rejects it," Netanyahu said.
Later on Friday, U.S. President Barack Obama telephoned Netanyahu to discuss the international talks on Iran's nuclear programme, the White House said in a statement.
"The president provided the prime minister with an update on negotiations in Geneva and underscored his strong commitment to preventing Iran from obtaining a nuclear weapon, which is the aim of the ongoing negotiations," the White House said.
Israel is not the only Middle East country fretting about Iran's nuclear ambitions. Saudi Arabia, Iran's chief rival for regional influence, has made clear to Washington that it does not like the signs of a possible U.S.-Iran rapprochement.
Israel has repeatedly suggested that it might strike Iran if Tehran did not shelve its entire nuclear programme and warned against allowing it to maintain what Israel sees as a nascent atomic bomb capability. Iran says its nuclear activities are geared only to civilian needs and has refused to suspend them.
The fact that a deal may finally be feasible after a decade of rhetorical feuding rather than genuine negotiations between Iran and the West highlighted a striking shift in the tone of Tehran's foreign policy since the election in June of Hassan Rouhani, a pragmatic former nuclear negotiator, as president.
NO MAJOR SANCTIONS EASING
Iran, which harbours some of the world's largest oil and gas reserves, wants the six powers to lift increasingly tough restrictions that have slashed its daily crude sales revenue by 60 percent in the past two years.
Iran and the powers are discussing a partial nuclear suspension deal covering around half a year. If a preliminary deal is nailed down, it would only be the first stage in a process involving many rounds of intricate negotiations in the next few months aimed at securing a permanent agreement.
One idea under consideration is the disbursement in instalments of up to about $50 billion of Iranian funds blocked in foreign accounts for decades. Another step could be temporarily relaxing restrictions on precious metals trade.
A further step could be Washington suspending pressure on countries not to buy Iranian oil. Diplomats say that such a move by Washington could be immediate and easily reversible if Iran failed to meet its obligations under a deal.
Negotiators have limited political room to manoeuvre as conservatives in Tehran and in Washington could denounce any agreement they believed went too far and seek to undermine it.
One Western diplomat told Reuters that Israel's fury at the proposed deal might actually make it easier for Rouhani to sell the interim deal to sceptics in Iran's powerful security and clerical elites who are wary of U.S. overtures to Tehran 33 years after Washington broke off diplomatic relations.
The United States has said world powers will consider some sanctions relief, while leaving the complex web of U.S., EU and U.N. restrictions in place, if Iran takes verifiable steps to rein in its nuclear programme.
Israel has argued against sanctions relief until Iran has scrapped its enrichment facilities.
Lending urgency to the need for a breakthrough was a threat by the U.S. Congress to pursue tough new sanctions on Iran. Obama has been urging Congress to hold off on more punitive steps to isolate Iran, demanded by Israel, to avoid undermining the delicate diplomatic opening with the country.
But many U.S. lawmakers, including several of Obama's fellow Democrats, believe tough sanctions forced Iran to the negotiating table in the first place and that more are needed to discourage it from diverting enrichment toward bomb-making.
Iran and the United States have had no diplomatic relations since soon after the 1979 Islamic Revolution that overthrew the U.S.-backed monarchy. Their mutual mistrust and enmity may pose the most formidable obstacle to any nuclear settlement. (Additional reporting by Louis Charbonneau and Fredrik Dahl in Geneva and Marcus George in Dubai; Editing by Bill Trott)