* Germany insists Cyprus hit banks to win bailout
* Merkel ally says Nicosia "playing with fire"
* German parties, media support tough Berlin stance
By Noah Barkin
BERLIN, March 22 (Reuters) - Europe's paymaster Germany stepped up pressure on stricken Cyprus on Friday, rejecting its proposal to nationalise pension funds to plug its finance gap and demanding it take an axe to its banks if it wants a bailout.
Chancellor Angela Merkel stuck to the hard line Berlin has been pushing for weeks, telling lawmakers that while she wanted to keep Cyprus in the euro zone, the country must first recognise it had no future as an offshore financial centre for wealthy Russians and Britons.
One of her conservative allies took to the airwaves to warn Cyprus it was playing a risky game by refusing to impose losses on depositors in its banking sector, which has swollen to eight times the size of the economy and is on the brink of collapse.
"I still believe we will get a settlement, but Cyprus is playing with fire," Volker Kauder, parliamentary leader for Merkel's Christian Democrats (CDU), told ARD public television.
The tough rhetoric from Berlin came as Russia rebuffed Cypriot demands for aid, leaving the island's increasingly isolated leaders mere days to satisfy their European partners or face a default that could reverberate across the 17-nation bloc.
EU leaders are now awaiting a "Plan B" from Cyprus. The government must come up with 5.8 billion euros by Monday, the day the European Central Bank has said it will cut off funds to Cypriot banks.
A closely-watched survey of German business morale on Friday showed that after a lull to start the year, the euro crisis was unnerving domestic firms again. The indicator from the Munich-based Ifo institute fell for the first time in five months.
With just six months to go until Germany holds an election, a poll for ZDF television showed that average Germans are also growing worried, with nearly two-thirds expecting the crisis to worsen and nearly half fearful for their savings.
In previous bailout standoffs with euro members like Greece, Merkel has demanded a high price for aid only to compromise at the last minute in order to avert disaster.
But with tiny Cyprus, a Mediterranean island of just a million inhabitants, she seems determined not to bend, even if that leads to bankruptcy.
"VICTORY FOR BLACKMAIL"
Comforting the Germans in their stance has been the relative calm of financial markets since the crisis in Cyprus flared up.
On Friday, the German benchmark stock index and most other European bourses were in positive territory, while the bonds of peripheral euro zone states like Spain and Italy were also trading higher.
That was partly due to a deal struck on Friday whereby Greece agreed to take over local units of stricken Cypriot banks, shielding its own financial sector from the fallout.
But it also suggested contagion from Cyprus may be limited, as German politicians have suggested in recent days.
Zsolt Darvas of Brussels-based think tank Bruegel said back-tracking by Berlin and other euro zone states at this point would be seen as a "victory for blackmail".
German media have also been withering in their criticism of the Cypriot government, which insisted at a euro zone meeting in Brussels a week ago that small savers in its banks be hit in order to limit losses on wealthy depositors.
President Nicos Anastasiades, elected only a few weeks ago, appears intent on preserving an economic model that relies on attracting billions of euros in foreign deposits, mainly from Russia, with loose regulations and low taxes.
Merkel explained in a closed-door session with conservative lawmakers, according to participants, that she considered this model dead and that Cyprus could not expect aid until it too acknowledged this.