UPDATE 1-New Zealand buys back rail network from Toll

(Adds Toll comment, detail, background)

WELLINGTON, May 5 (Reuters) - The New Zealand government said on Monday it would buy back the country's only rail operator from Australia's Toll Holdings Ltd (TOL.AX) after it could not agree future fees.

It said it would pay NZ$665 million ($520 million) for the operation, which includes inter-island passenger and freight ferries.

Finance Minister Michael Cullen said the privatisation of the rail network in the early 1990s had seen the asset run down.

"During the negotiations with Toll it transpired that buying the rail operating business including the ferries was the best way to increase investment in the industry and enable it to be more responsive to the needs of New Zealand customers," Cullen said in a statement.

The New Zealand government and Toll, Australia's biggest transport group, had been wrangling over the price Toll would pay for exclusive use of the state-owned rail network.

"The government will now avoid paying subsidies to third parties and we also avoid the ongoing disputes over the implementation of the National Rail Access Agreement that had the potential to destroy value in the business and erode the morale of the people who work in it," Cullen said.

Toll acquired control of listed rail operator Tranz Rail for NZ$230 million in 2003, but did not manage to mop up minority shareholders until late last year.

Tranz Rail was close to collapse under a mountain of debt, but a rescue package saw the New Zealand government buy back the track network and pledge NZ$200 million investment.

Toll gained exclusive use for an annual fee based on performance along with promises to invest in new rolling stock.

Toll said it was a reluctant seller.

"We felt that we needed more security around the access arrangement, we weren't able to get that, so this is a compromise position," Toll managing director Paul Little told a news conference.

Toll paid NZ$3 a share to buyout minorities last year, valuing the railway company at NZ$630 million.

The NZ government said it was paying the equivalent of NZ$3.16 a share.

Toll will retain the rail and road freight forwarding business, Toll Tranzlink. Proceeds of the sale will be used to pursue Toll's expansion into Asia, Little said.

The rail system employs 2,300 people, with mostly freight with some limited passenger routes, on 4,000 kilometres of track. Toll also operates the main ferry service between New Zealand's North and South Islands.

The state-owned railways were sold in 1993 to a consortium that included U.S. rail operator Wisconsin Central for NZ$328 million.

The New Zealand government holds a 77 percent stake in the country's national carrier Air New Zealand (AIR.NZ) after a NZ$885 million rescue package in 2002. ($1=NZ$1.28) (Additional reporting Adrian Bathgate) (Reporting by Gyles Beckford)