Turkey hopes releases head off crisis with military

* Markets likely to welcome release of ex-top brass

* But retired commanders might yet be charged

* Prosecutor notes investigation continuing

By Simon Cameron-Moore

ISTANBUL, Feb 26 (Reuters) - Turkey has freed three retired military commanders detained on suspicion of plotting to topple the Islamist-rooted government, but it remains unclear whether they will yet face charges.

Turkish financial markets will probably welcome on Friday their release as a sign the likelihood of a full-blown confrontation may be receding.

But a prosecutor noted investigations were continuing, leaving the possibility that the three men who were detained at the start of the week may yet faces charges. Forty-seven others detained with them remain in detention.

The nation, and foreign investors, have feared that Prime Minister Tayyip Erdogan's AK Party is heading into outright confrontation with the powerful, secularist military as tensions escalated in the Muslim nation on the edge of Europe.

But the move by prosecutors on Thursday evening to free former heads of the air force and navy, along with a former deputy chief of the general staff, could ease tensions with the AK Party government elected in 2002 with a huge majority.

Though the military has ousted four governments in the last 50 years, most people believe the generals would not dare destroy a newfound confidence in democracy by launching a coup.

Turkey is both a NATO member and a candidate to join the European Union, and Western allies want to see the country mature as a democracy.

But its politics appear increasingly polarised between the secular, conservative nationalists who represent the old guard and the AK Party, which has won over investors with market-friendly reforms despite roots in political Islam.

Erdogan held crisis talks with President Abdullah Gul and armed forces chief General Ilker Basbug on Thursday, and said the meeting went "very well".

Erdogan will attend an AK Party function scheduled for Friday morning with the controversy far from over.

INVESTIGATION CONTINUES

According to the state-run Anatolian news agency, Istanbul Deputy Chief Prosecutor Turan Colakkadi said the ex-commanders, who were first questioned in the probe late last year, were believed to be unlikely to abscond or interfere in the investigation.

The Istanbul stock market's benchmark index .XU100 closed 1.85 percent down on Thursday, having lost more than three percent the previous day.

Likewise the lira IYIX= has lost over 3 percent against the dollar since trouble erupted last week between the government and the judiciary, traditionally the other main bastion of secularism.

The clash began when a prosecutor investigating an Islamist group in the provinces was detained on suspicion of belonging to an ultra-right wing militant group, dubbed Ergenekon, that police said was unearthed two years ago.

Some 200 people have been detained in the Ergenekon investigation, including several retired military officers. But critics say the government has also used the investigation to hound political opponents. The government denies it.

The judicial establishment has said the detention of the prosecutor was illegal, and replaced four fellow prosecutors who carried out the order.

That move prompted the government to threaten to force through constitutional changes to reform the judiciary, and raised speculation that Turkey's chief prosecutor could try to have the AK Party banned.

The country was plunged into crisis two years ago, when the chief prosecutor tried and failed to shut down the ruling party on grounds that it had become a focal point for Islamist activities.