* Fiat, Fiat Industrial to quit Confindustria on Jan. 1, 2012
* Fiat to produce Jeep SUV and Alfa Romeo engine in Italy
* Shares down 3.5 pct, sector down 4 pct (Adds analyst, background, shares)
MILAN, Oct 3 (Reuters) - Italy's largest manufacturer Fiat SpA is to quit the country's leading business group, Confindustria, as it believes the group's collective labour contracts put it at a disadvantage on the international stage.
The move comes after a groundbreaking deal to boost productivity and cut absenteeism struck by the carmaker last year was subjected to legal challenges by a trade union and after national legislation introducing greater labour flexibility met resistance.
"Fiat, which is engaged in the creation of a major international group ... cannot afford to operate in Italy in an environment of uncertainty that is so incongruous with the conditions that exist elsewhere in the industrialised world," CEO Sergio Marchionne said in a letter to Confindustria published on Monday.
The letter, addressed to Confindustria leader Emma Marcegaglia, said the resignation of Fiat and its sister company Fiat Industrial would be effective on Jan. 1, 2012.
At the heart of the row between Fiat and Confindustria is how far individual companies can stray from national labour contracts to which the business group's members are usually bound and negotiate alternative deals at a factory level.
Marchionne, who also runs Chrysler and is currently engaged in contract negotiations with the U.S. United Auto Workers union, has made 20 billion euros of planned investments in Italy conditional on unions giving full backing to the new labour contracts introduced at three of Fiat's Italian plants.
He has also threatened to move production abroad.
However, in separate statements on Monday, Fiat said it would produce a Jeep-branded sports utility vehicle at its Mirafiori plant near Turin in the second half of 2013, while an Alfa Romeo turbo engine would start production in early 2013.
Shares in Fiat were down 3.5 percent by 0818 GMT, broadly in line with the European auto sector , which was down 4 percent.
The stock has lost nearly 40 percent since the beginning of the year, hit by worries about a U.S. economic slowdown and weak sales in Europe.
A Milan-based analyst said the Confindustria decision was "very clear" and unlikely to be turned around by Jan. 1, 2012.
The production decisions were already known and had no impact on his rating or earnings estimates, the analyst said, asking not to be named.
Last year Fiat and Chrysler said they would invest 1 billion euros to build as many as 280,000 vehicles a year at Mirafiori, including Jeep and Alfa Romeo models to begin production before the end of 2012. (Writing by Michel Rose; Editing by Will Waterman)