* Watchdog body approves budget amended by lawmakers
* President had accused MPs of violating constitution
* Row comes three months before presidential election
By Fredrik Dahl
TEHRAN, March 18 Iran's legislative watchdog has approved a 2009-10 budget bill after parliament made changes that dealt an economic policy blow to President Mahmoud Ahmadinejad, three months before an election.
Ahmadinejad, who is expected to seek a second four-year term in the June 12 vote, had accused the legislature of violating the constitution by removing a key plank of his plan to reform Iran's system of hefty subsidies from the budget proposal.
But influential Speaker Ali Larijani rejected Ahmadinejad's criticism and Iranian media said the Guardian Council, which vets laws to ensure they adhere to Islamic principles, backed the amended budget bill on Tuesday.
MPs argued that the subsidy reform would further stoke inflation, now running at more than 20 percent annually, at a time when the world's fourth-largest oil producer is facing declining revenue from its crude exports.
Ahmadinejad had wanted to raise energy and utility prices and compensate low-income families with direct cash payments.
"From a political point of view, Ahmadinejad lost the battle of the budget," said Saeed Laylaz, editor of the Sarmayeh business daily and an outspoken critic of the government. "But I'm not sure it is over yet."
The dispute has highlighted objections to Ahmadinejad's economic policies from fellow conservatives such as Larijani, who said the president was interfering in parliamentary affairs.
The Guardian Council approved the bill on the same day that moderate former president Mohammad Khatami withdrew from the presidency race to avoid splitting the reformist vote, throwing his weight behind former Prime Minister Mirhossein Mousavi.
Khatami oversaw a thaw in ties with the West during his 1997-2005 tenure but they deteriorated again under Ahmadinejad, who often rails against Iran's Western foes.
Laylaz said the outcome of the budget debate showed that Ahmadinejad, who came to power in 2005 pledging to share out Iran's oil wealth more fairly, had been weakened politically.
But Ebrahim Hosseini-Nasab, an economics professor at Tehran's Tarbiat Moddares University, said the government could re-submit its reform proposal in a supplementary bill and that a compromise with parliament was still possible.
Critics accuse Ahmadinejad of squandering the windfall oil revenue Iran earned when crude prices were soaring, leaving it more vulnerable in times of need, such as now.
The president argues his subsidy reform plan would help "implement justice and remove discrimination", and that change is more urgent now crude has fallen by around $100 a barrel from July's peak of $147, hitting Iran's main source of revenue. (Additional reporting by Parisa Hafezi; Editing by Mark Trevelyan)