UPDATE 4-California budget woes now 'fiscal emergency'

* Governor Schwarzenegger declares fiscal emergency

* Lawmakers forced into special session to tackle budget gap now seen at $26.3 billion

* Democrats, Republicans at odds over plugging shortfall

* Plan for "IOUs" to help conserve dwindling cash

* State officials say paying bondholders a top priority (Recasts, adds bullet points, new shortfall estimate)

By Jim Christie

SAN FRANCISCO, July 1 (Reuters) - California Gov. Arnold Schwarzenegger on Wednesday declared a fiscal emergency to force lawmakers into a special session to tackle a state budget gap that has widened to $26.3 billion from $24.3 billion after they failed to close it on Tuesday.

Lawmakers debated late into the night Tuesday but could not agree on a plan to balance California's budget for its new fiscal year, which began early Wednesday morning.

That cleared the way for state officials to suspend payments owed to vendors and local agencies, who instead will get "IOU" notes promising payment.

The notes would mark the first time in 17 years the most populous U.S. state's government would have to resort to the unusual and dramatic measure -- and would follow warnings by Wall Street that the state's credit ratings may be lowered, which would increase its borrowing costs.

"Though the legislature failed to solve our budget problem yesterday, rest assured that solving the entire deficit remains my first and only priority, and I will not rest until we get it done. I will not be a part of pushing this crisis down the road -- the road stops here," Schwarzenegger said in a statement.

While California lawmakers struggle with budget deadlines nearly every year, this budget fight is taking place amid the state's worst drop in revenues from personal income taxes since the Great Depression as recession and rising joblessness worsen damage done to the state economy from the housing slump.

Democrats, who control the legislature, could not convince Republicans to either back their plans to tackle the shortfall or make a stopgap effort to ward off the IOUs. The two sides agree on the need for spending cuts, but are split over whether to raise taxes to help fill the gap.

Democrats have pushed for new revenues while Republican lawmakers and Schwarzenegger, also a Republican, have ruled out tax increases. They want deep spending cuts to balance the budget. Democrats say that would slash the state's safety net for the needy to the bone.

California bonds due in 10 to 30 years traded stronger in the secondary municipal market as it priced in a missed budget deadline, said Municipal Market Data analyst Domenic Vonella.

"We've seen Cal GO paper widen for the last three weeks or so ... Today things are a few basis points better," added Parker Colvin, head of municipal securities trading at Stone & Youngberg in San Francisco.