* Mehsud was one of Pakistan's most wanted men
* Attack deals major blow to Pakistan insurgency
* Funeral due on Saturday; peace talks likely scuttled
By Mehreen Zahra-Malik and Jibran Ahmed
ISLAMABAD/PESHAWAR, Pakistan, Nov 1 (Reuters) - The head of the Pakistani Taliban was killed by a U.S. drone strike on Friday, security and Taliban sources said, in a blow to the fragmented movement fighting against the nuclear-armed South Asian nation.
Hakimullah Mehsud was one of the most wanted and feared men in Pakistan with a $5 million U.S. bounty on his head, leading an insurgency from a mountain hideout in North Waziristan, the Taliban's stronghold on the Afghan frontier.
"We confirm with great sorrow that our esteemed leader was martyred in a drone attack," a senior Taliban commander said.
In Washington, two U.S. officials confirmed Mehsud's death in a CIA drone strike. They spoke on condition of anonymity.
At the White House, a spokeswoman said officials had seen the reports Mehsud may have been killed in Pakistan. "We are not in a position to confirm those reports, but if true, this would be a serious loss" for the Pakistan Taliban, Caitlin Hayden, spokeswoman for the National Security Council, said in a statement.
She noted that the Pakistan Taliban had claimed responsibility for the failed bomb plot at New York's Times Square in 2010, and that Mehsud was wanted in connection with the killing of seven CIA employees in Afghanistan in 2009.
The killing of Mehsud was the latest setback for the Pakistani Taliban, a group aligned with its Afghan namesakes and which has staged attacks against Pakistani armed forces and civilians in its fight to topple the government.
His death is almost certain to scuttle the prospect of peace talks between the Taliban and the government of Prime Minister Nawaz Sharif, who won a landslide election victory in May by promising to bring peace to the country.
Pakistan had informed the United States and Britain that peace talks with the Pakistani Taliban were imminent, said Bruce Riedel, a former CIA and White House official with extensive experience in the region.
"So the drone strike is very awkward and difficult for Sharif. Conspiracy theories in Pakistan will assume he agrees to the strike even as he proposed peace talks with Mehsud," Riedel said via email. "Another setback for U.S.-Pakistan relations ironically."
The government never clarified which factions of the Taliban it was willing to talk to or whether it would comply with the Taliban's demands to release its prisoners and withdraw the army from Taliban strongholds in Pakistan's tribal areas.
The government, which officially condemns U.S. drone strikes, issued its usual statement denouncing the attack, but did not comment on reports of Mehsud's death.
Mehsud's funeral will be held on Saturday at 3 p.m. (1000 GMT) in Miranshah, the main regional city, the Taliban commander said, an event likely to stir tension in a region already suffering from an escalating insurgency.
Pakistan, a nation of 180 million people, has been plagued by violence, including the homegrown Taliban insurgency that has cost tens of thousands of lives.
But the Taliban has been weakened by a series of counter-attacks. In May, a U.S. drone strike killed Mehsud's second-in-command, and one of his most trusted lieutenants was captured in Afghanistan last month.
A senior Pakistani Taliban source said it held an emergency meeting after Mehsud's death and approved two commanders, Maulvi Omar Khalid and Maulana Fazlullah, to replace him.
"Among these men, one will replace our slain Ameer (leader). Maulvi Omar Khalid ... is most likely to replace Hakimullah Mehsud," said a senior Pakistani Taliban official.
He said the Taliban would hold a tribal meeting early on Saturday to decide on further actions. "You will see our reaction," he said.
The Pakistani Taliban acts as an umbrella for various jihadist groups operating in Pakistan's lawless tribal belt, which are separate, but allied to the Afghan Taliban.
Several intelligence, army and Taliban sources across Pakistan confirmed Mehsud, believed to be in his mid-30s, had been killed in the drone strike in North Waziristan.
His bodyguard and driver were also killed, they said.
The drones fired four missiles at a compound in Danda Darpa Khel, a village about 5 km (3 miles) from the regional capital of Miranshah, sources said. Mehsud had been attending a gathering of 25 Taliban leaders to discuss the government's offer of talks, they said.
The information could not be independently verified because journalists have no access to the affected areas.
Mehsud was brought into the insurgency by his cousin Qari Hussain, who was the Taliban's top trainer for suicide bombers until he was killed in a drone strike.
He lacked formal education or religious training, but Mehsud was a popular figure known for his jokes and interest in modern technology, said Reuters journalists who had met him.
He was the driver for the former head of the Pakistani Taliban, and then rose through the ranks to become the movement's spokesman, although he was known for his emotional outbursts during conversations.
Mehsud took over the Pakistani Taliban in August 2009 after a drone strike killed the previous leader, his mentor.
Mehsud had two wives and moved frequently because of his fear of U.S. drone strikes.
In recent months, analysts say rivalries with other Taliban commanders over revenues from extortion and kidnapping had sharpened, rising tension within the fragmented movement.
The United States offered $5 million for Mehsud's capture after he appeared in a farewell video with the Jordanian suicide bomber who killed seven CIA employees at a base in Afghanistan in 2009.
U.S. prosecutors have charged him with involvement in the attack. The Taliban is also accused of plotting to bomb Times Square in 2010.
Although Mehsud's death will bring calls for revenge, it may make negotiations with the militants easier in the long run, said Saifullah Mahsud, director of the Pakistani think tank FATA Research Center.
"Hakimullah Mehsud was a very controversial figure and he had very tough demands," he said.
But the strike did not signal the end of the Pakistani Taliban, he said.
"It's a very decentralised organisation. They've lost leaders to drone strikes before."