KUALA LUMPUR, March 5 When dozens of armed Filipinos landed by boat on Malaysia's part of Borneo island last month claiming to be a "royal army" and pressing an obscure historic claim, it seemed like a bizarre incident that would soon be resolved and forgotten.
Three weeks later, 27 people including eight Malaysian policemen have been killed, sparking a political crisis ahead of elections for both the Philippine and Malaysian governments and raising concerns of instability in resource-rich Sabah state.
While the violence has been contained so far to a small corner of Sabah, it signals that militants left out of a peace deal between Manila and the Philippines' main Muslim rebel group could be renewing their focus on the region.
Prolonged insecurity could also affect Sabah's huge palm oil industry and dampen growing investor interest in energy and infrastructure projects in the state, although the main oil fields are far from the trouble.
The group, numbering about 180, say they are descendants of the sultanate of Sulu in the southern Philippines, which ruled parts of northern Borneo for centuries. They are demanding recognition and an increased payment from Malaysia for their claim as the rightful owners of Sabah.
The violence presents Malaysian Prime Minister Najib Razak with a security headache that could delay an election that must be held by June, adding to nervousness among investors over what could be the country's closest ever polls.
Leaders of the ruling United Malays National Organisation (UMNO) were discussing delaying the election until beyond April, a senior UMNO official told Reuters. Malaysia's parliament must be dissolved for elections by the end of April, but Najib had been expected to hold the polls as early as late March.
"It will be difficult to hold elections with such a situation going on in Sabah," the UMNO official said.
"Not only is it a security issue, it is going to be a huge election issue that the opposition will manipulate."
Oil majors such as ConocoPhillips and Shell have poured in billions of dollars to develop oil and gas fields in Sabah. Chinese companies have been investing in hydro-power and coal mining, and Sabah is a popular tourist spot with pristine beaches, diving sites and rich tropical wildlife.
A standoff with the armed group erupted in bloodshed on Friday when two policemen and 12 militants died in a firefight near a coastal village. Violence hit at least two other locations over the weekend.
IMMIGRATION COMPLICATES CRISIS
Malaysia has rejected the group's renewed claim on Sabah, which was leased by the sultanate of Sulu to a British trading company in the 19th century and later absorbed by Kuala Lumpur. Sulu is a Philippine island chain that lies between Sabah and the Philippines' Mindanao island. The sultan's family are traditional rulers, with no formal political powers.
For Malaysia, the crisis is complicated by the illegal immigration of Filipinos to Sabah, largely to work in palm oil plantations. Sabah's population has more than quadrupled since the early 1970s and the Philippine government says about 800,000 Filipinos now live there.
Sabah residents have been transfixed in recent weeks by a public inquiry into allegations that illegal immigrants were handed identity cards by UMNO in a citizenship-for-votes scheme.
Much of the population in the area affected by the violence has cultural and family links to the southern Philippines -- an hour away by speedboat -- raising doubts over their allegiance.
That could hinder efforts to capture the gunmen and make immigration an awkward issue for Najib. Voters in Sabah, traditionally a bastion for the UMNO-led National Front coalition, could swing the election to the opposition if it can build on recent gains there.
"The problem Malaysia's government faces is the prospect of many of these Sulu people having Malaysian identity cards," said the UMNO source. "Many of them have relatives in Sabah."
Malaysia deported nearly 300 illegal Filipino immigrants on Sunday, a sign that ties between the neighbours could be frayed. Philippine Foreign Minister Albert del Rosario flew to Kuala Lumpur on Monday to urge "maximum tolerance" in dealing with the remaining members of the group.
The crisis could leave Najib's government open to criticism of a lax security response for allowing the gunmen to enter and for not cracking down on them sooner. Forces surrounding the group initially took a softer approach, even giving them food when their supplies ran low.
Opposition leader Anwar Ibrahim criticised Najib on Monday for "weak" leadership on the crisis and called for a special session of parliament to discuss the situation.
Malaysia sent seven army battalions to the region on Monday to reinforce police, state media said.
Philippine President Benigno Aquino, facing congressional elections in May, has come under pressure from opponents for supporting Malaysia's rejection of the group's claim to Sabah, which remains a dormant Philippine policy goal.
Aquino's allies in turn have hinted that the political opposition encouraged the intrusion as a way of undermining the peace deal signed with Muslim rebels last year and embarrassing the government ahead of the May elections.
"ROYAL ARMY" ACTING ALONE?
The trouble looks to be partly the result of the deal signed by the Philippine government and Moro Islamic Liberation Front (MILF) rebels in October to end a 40-year conflict. That agreement was brokered by Malaysia.
Jamalul Kiram, a former sultan of Sulu and brother of the man Philippine provincial authorities regard as the sultan, said the peace deal had handed control of much of Sulu to the MILF, ignoring the sultanate.
"I think some groups are trying to throw a monkey wrench in the peace process and embarrass the government," said Rex Robles, a retired navy commodore and security analyst in Manila.
Malaysian security officials have said they suspect the involvement of another Philippine rebel group, the MNLF, which is led by Nur Misuari, an opponent of the peace deal. They said the gunmen appeared to be well trained and experienced in combat.
But a senior Philippine security official said Misuari was not believed to be involved because the group in Sabah came from the island of Tawi-Tawi, which is not a known MNLF stronghold.
Prolonged violence could affect the huge palm-oil industry in Sabah, which employs 300,000 legal foreign plantation workers and many more illegal immigrants from the Philippines and Indonesia. Palm oil firms are already experiencing transport delays due to the violence, said one industry official who asked not to be identified. (Additional reporting by Siva Sithraputhran in KUALA LUMPUR; Manuel Mogato in MANILA; Florence Tan in SINGAPORE; Editing by Dean Yates)