* EU and Israel at odds over scientific research programme
* Relations at their most fractious in years, diplomats say
* EU to spend 70 billion euros on research between 2014-2020
By Luke Baker
BRUSSELS, Nov 6 (Reuters) - As Israel looks warily west in the hope that the United States has its back in any conflict with Iran, it might do well to glance north and consider its relations with Europe too.
Over the past four years, ties between the European Union and Israel have grown increasingly fractious, with Brussels seldom missing an opportunity to lambaste Benjamin Netanyahu's government for building settlements on occupied Palestinian land and restricting access to large portions of the West Bank.
In a series of statements since June 2009, soon after Netanyahu came to power and settlement expansion began, EU foreign ministers have steadily sharpened their tone, leading to the publication in July this year of strict new rules on how EU funds can be distributed to Israeli organisations.
The funding guidelines, which effectively ban EU money being allotted to Israeli research institutes and other entities that have operations in the West Bank and East Jerusalem, are a source of great aggravation to Israel.
From Europe's point of view, they merely put down on paper what has been a long-held position: that the occupation of Palestinian land is illegal under international law and EU governments don't want to finance activities there.
Either way, it has brought relations to a tense pass, one of the worst periods diplomats can recall in the past decade, and the situation may well get worse.
"There has been a steady downward trend in relations, although perhaps not as bad as sometimes portrayed in the Israeli media," said Mattia Toaldo, a specialist on Israel and the Middle East at the European Council on Foreign Relations.
"The guidelines are part of a political trend that has been part of EU policy since the 1970s but has become more explicit since 2009, and has been stepped up since last December."
While the EU, which provides more than 450 million euros a year to the Palestinians, is regarded by Israel as a less substantial ally than the United States, it still matters a great deal, especially in terms of trade and investment.
The EU is Israel's largest trading partner, supplying nearly 35 percent of Israel's imports, the largest share, while more than a quarter of its exports go to the EU.
In 2000, the EU granted the country preferential trade terms, mainly for agricultural and industrial goods, and there has been a steady rise in cooperation on scientific research and technology too, which is where the guidelines come in.
From next year until the end of the decade, the EU will spend 70 billion euros - 10 billion a year - on scientific research and development, a programme called Horizon 2020.
Israel is the only non-EU country invited to take part and will contribute some of the funding, around 600 million euros. In return, its top-notch scientists and researchers will gain access to the wider funding pot, with the expectation that they will secure far more financing than the country puts in.
And there's the rub. The EU's guidelines proscribe any of the money going to entities in the West Bank or East Jerusalem, even though some of the financing ultimately comes from Israel.
"As it stands, we cannot sign Horizon 2020," Deputy Foreign Minister Ze'ev Elkin told Reuters last month. "It would force us to discriminate against our own institutions."
When the guidelines were published in July there was widespread finger-pointing by Israel over whether the EU had kept it informed of the plans. Some Israeli officials suggested the EU had been less than transparent.
Records show Israel was in fact briefed by the EU five times before the publication, although it had essentially no say in shaping the language drafted by the European Commission.
Since then, senior officials have met in Brussels and Jerusalem to try to work out a way of interpreting the guidelines that is acceptable to both sides. There has been little progress so far. Another meeting is due before the end of the month to try to strike a deal in time for Horizon 2020 to begin as planned from January 1, 2014.
While EU and Israeli officials are reasonably hopeful that a compromise can be reached in time, others are not so sure. Toaldo of the European Council on Foreign Relations expects Horizon 2020 to start without Israel, but with the door left open for them to join at some point in the coming years.
That would mark a further decline in ties, although not an irreparable break. However, another set of EU proposals, this time on the labelling of goods made by Israel at factories or farms on the West Bank, is in the pipeline and is likely to be even more sensitive for Israel and disruptive to relations.
Asked when rules on labelling would be published, a senior EU official said: "These are discussions that take some time. They are proceeding and they are rather sensitive ones, so I think one can expect that it may take some more time."
In the past, the EU and Israel have always managed to patch up their differences. A similar outcome is likely now - no one expects a fundamental breakdown in diplomatic relations.
But the EU, which wants Israel to change policy on settlement building and loosen restrictions in the West Bank, specifically Area C that makes up 60 percent of the territory and is controlled by Israeli security, does not appear minded to soften its approach. It thinks the pressure is working.
Toaldo agrees that the EU's approach is having an impact, whether intentional or not, for example in helping to shunt the Israelis and Palestinians back to talks. But he also warns against seeing such an attitude as a workable policy.
"I would say one step at a time. You can strain EU-Israel relations too much and too quickly," he said, adding that while Europe matters to Israel, the reverse is also true.