(Adds State Department spokeswoman and background, paragraphs 10-13)
By Frank Jack Daniel and David Brunnstrom
NEW DELHI/WASHINGTON, Jan 8 (Reuters) - India ordered the United States on Wednesday to close down an embassy club for expatriate Americans in New Delhi, escalating a diplomatic row that has brought faultlines in ties between the nations out in the open.
Furious at the arrest, handcuffing and strip search of its deputy consul in New York last month, India initially reacted by curtailing privileges offered to U.S. diplomats. The officer, Devyani Khobragade, was accused by prosecutors of underpaying her nanny and lying on a visa application,
Nearly a month on, the row has started to affect the wider relationship between the world's two largest democracies, with one high-level visit by a senior U.S. official already postponed and a visit scheduled for next week by U.S. Energy Secretary Ernest Moniz looking doubtful.
Both sides have said the relationship is important and will not be allowed to deteriorate - Washington needs New Delhi on its side as U.S. troops pull out of Afghanistan and it engages with China. Millions of Indians have made the United States their home and bilateral trade is worth about $100 billion a year.
The row over Khobragade, which should not have been more than an easily resolved irritation, has plunged the two countries into a crisis described by Indian media as the worst since New Delhi tested a nuclear device in 1998.
"I'm a little worried it may spin out of control," said Lalit Mansingh, a former Indian ambassador to the United States who has also served as India's top diplomat and is now retired.
India stepped up the pressure on Wednesday ahead of a Jan. 13 court appearance where Khobragade could be indicted, ordering the U.S. embassy in Delhi to stop receiving non-diplomats at an embassy club popular with expatriate Americans for its swimming pool, restaurant and bar.
Americans working in the Indian capital have been frequenting the club for decades. An Indian government source said the club should not be offering services to non-diplomats when it has tax-free status.
A U.S. embassy spokesman was not immediately available for comment.
In Washington, State Department spokeswoman Jen Psaki stressed the importance of relations with India and said the United States "endeavours to always be in compliance with local laws and regulations."
"We are continuing our conversations with the Indian Government ... with the importance of the broad strategic U.S.-India partnership firmly in mind," she said.
India had already curtailed privileges offered to U.S. diplomats to bring them in line with the treatment of Indian envoys to the United States. Since December, the U.S. ambassador in Delhi can be subjected to airport frisking and most consular staff have reduced levels of immunity.
Concrete barriers were removed from a road near the U.S. embassy last month, apparently in retaliation for the loss of a parking spot for the Indian ambassador in Washington.
India is also preparing to take steps against the embassy school, which it suspects may be employing some staff in violation of visa requirements, a government source said.
Despite an overall improvement in ties since the end of the Cold War, the Khobragade dispute has brought into the open the lingering wariness between the two countries. Over the past year, there has been increasing friction over trade, intellectual property rights and visas for Indian IT workers.
There is also a legacy of mistrust, with some Indian officials whose professional life began when India was a close partner of the Soviet Union still not convinced Washington is a reliable ally.
Despite close security and economic cooperation now, many officials recall U.S. support of India's old enemy Pakistan and some believe Washington sees a strong India as a threat.
"For 50 years we were led to believe that the United States was an adversary. For the last 10 years we have been experimenting with a strategic partnership. It is not a done deal." said Mansingh.
Among some U.S. diplomats there is a perception that while India insists on respect and friendship from Washington, it fails to deliver either in support on issues such as Iran or Afghanistan, or by giving enough commercial access to U.S. businesses.
To defuse the spat, India wants the U.S. State Department to approve Khobragade's transfer to its U.N. mission in New York, a move it believes would give her immunity from prosecution.
If that doesn't happen before the U.S. government commences a preliminary hearing or files an indictment, India could take more retaliatory measures, a government source with knowledge of the affair told Reuters.
U.S. officials hope for a resolution of the row through some sort of plea-bargaining process, but if it persists, the next casualty could be the trip by Moniz, who is due in Delhi for talks to promote trade and investment in the energy sector. The talks usually include discussions of civil nuclear trade between India and the United States.
For now, the trip has not been cancelled. However, the U.S. Assistant Secretary of State for South Asia, Nisha Desai Biswal, has postponed her first visit to India, which was due on Jan. 6, to avoid it becoming embroiled in the dispute.
State Department spokeswoman Marie Harf said Biswal would visit India as soon as possible, but no date had yet been set.
"Has an era of steadily improving ties between the two countries come to an end?" asked Indian Human Resource Minister Shashi Tharoor in a column published this week.
"Indian-American relations had been strengthening owing to both sides' shared commitment to democracy, common concerns about China, and increasing trade and investment," he wrote.
"The Khobragade affair suggests, however, that all this is not enough: sustaining a strategic partnership requires, above all, mutual respect."
The United States had high hopes India would emerge as a counterbalance to a rising China and a new engine for the U.S. economy.
However, there is a widespread sense that the relationship has drifted since a sharp improvement brought by India's 2009 deal on nuclear cooperation with the Bush administration.
Frustration has grown among the U.S. corporate lobby. Indian sourcing rules for retail, IT, medicine and clean energy technology are contentious and U.S. companies gripe about "unfair" imports from India of everything from shrimp to steel pipes. In June, more than 170 U.S. lawmakers signed a letter to Obama about Indian policies they said threatened U.S. jobs.
Now, with general elections due in India in four months, and mid-term elections in the United States in November, the fear is that the current row will make it harder for both sides to stick their necks out and make progress on thorny issues such as liability for nuclear equipment suppliers.
"There is such a long laundry list of concerns on the American side that seem to be ignored or slow rolled in India,' said Persis Khambatta at the Center for Strategic and International Studies think tank. "The risk is that this (Khobragade) incident will dig up a lot of frustration that had built up." (Additional reporting by Aruna Viswanatha and Valerie Volcovici in Washington and Joseph Ax in New York and Sruthi Gottipati in New Delhi; Editing by Raju Gopalakrishnan and Andrew Hay)