* Parliament passes bill to which government objected
* Government says will seek to block any spending increase
* Portuguese assets under pressure but off lows
(adds protest, quotes, stock closing price)
By Andrei Khalip and Shrikesh Laxmidas
LISBON, Feb 5 (Reuters) - Portugal's parliament passed on Friday a controversial bill on regional finances, defeating the minority Socialist government which said it would try to block the law by other means, warning it will raise the budget gap.
Lawmakers cast 127 votes in favour of the law and 87 voted against in the 230-seat parliament despite government warnings that the move will send a wrong signal to the markets, already roiled by concerns over Portugal's public finances.
The cost of insuring the country's debt against default (CDS), which hit record highs earlier on Friday, retreated in the afternoon following other euro zone CDSs. Finance Minister Fernando Teixeira dos Santos has said earlier the government could apply another law on the budget framework to cut any spending resulting from the new regions law that breaks the limits set in the draft budget. The Socialists will also question the bill's constitutionality in the Constitutional Court, Parliamentary Affairs Minister Jorge Lacao said.
"We cannot aggravate debt and deficit with wasteful measures. We cannot follow that line because of the responsibility we have with controlling spending and public debt," he said.
Some analysts say these moves could jeopardise a shaky deal with the opposition to pass this year's budget. The parliament will start budget discussions next Wednesday.
"There is political risk in Portugal. As long as we don't have positive news on that front, the negative trend in the market will continue," said Jose Gabriel, a trader with Probolsa brokerage in Lisbon.
The largest opposition party, the centre-right PSD, last month agreed to abstain in the budget vote to allow its passage.
But opposition politicians played down the government's statements against the regional finance bill as "over-dramatising" and made no reference to the budget.
"It was all acting (by the government)", PSD leader Manuela Ferreira Leite told reporters. "They are convinced they can block the execution of this law. If so, why all this theatre?"
Pedro Soares, one of the leaders of the right-wing opposition CDS-PP party in parliament, said all the additional expenses with the autonomous regions of Madeira and the Azores under the new law would amount to a deficit increase of just 0.03 percent of gross domestic product.
That compares to a target of 8.3 percent deficit the government set in the 2010 budget presented last week. Last year's fiscal gap had spiked to 9.3 percent from 2.6 percent in 2008 and the government has pledged to the European Union it will bring the deficit below 3 percent by 2013.
Ratings agencies have said the announced deficit cut for 2010 was unambitious and last month urged Portugal to enact further deficit cuts in 2011-2013, warning they would downgrade Portugal's ratings if no credible austerity steps are taken.
In central Lisbon, several thousand public administration workers marched to the finance ministry, to protest against the government's freeze on public sector wages -- one of the main spending control measures in the draft budget for 2010.
Called by the 300,000-strong Common Front public workers' union, the protesters arrived from across Portugal in over 100 buses. The protest was the first sign of social unrest after the draft budget announcement last week.
"There has to be a pay rise. The country already has huge inequalities, youngsters have precarious work conditions, unemployment is rising. It's just unacceptable," said Nuno Amaral, a computer engineer from a suburb of Lisbon.
Alongside Greece and Spain, Portugal is one of a handful of euro bloc countries that face intense pressure to get their public finances in order and calm markets which are worried about the risks of a sovereign default.
Portuguese stocks slumped around 5 percent on Thursday and shed another 1.4 percent on Friday. Bond spreads that blew out over 15 points the previous day were practically unchanged at 160 bps over benchmark German government bonds. (Additional reporting by Daniel Alvarenga; Editing by Ron Askew)