* Judge says coverage requirement unconstitutional
* Obama administration expected to appeal ruling
* Little movement in healthcare shares (Adds reaction from state officials, Cantor)
By Lisa Lambert and Jeremy Pelofsky
WASHINGTON, Dec 13 A U.S. judge in Virginia on Monday declared a key part of President Barack Obama's landmark healthcare law unconstitutional in the first major setback on an issue that will likely end up at the Supreme Court.
U.S. District Judge Henry Hudson, appointed to the bench by President George W. Bush in 2002, backed arguments by the state of Virginia that Congress exceeded its authority by requiring Americans to start buying health insurance in 2014 or face a fine.
"This dispute is not simply about regulating the business of insurance -- or crafting a scheme of universal health insurance coverage -- it's about an individual's right to choose to participate," Hudson wrote, adding the provision invites an "unbridled exercise of federal police powers."
But he declined to invalidate the entire healthcare law, a small victory for Obama, whose administration will appeal the decision.
The law is a cornerstone of Obama's presidency, aiming to expand health insurance to cover millions of uninsured Americans while trying to curb costs.
Healthcare insurers, which include companies such as Aetna Inc (AET.N) and WellPoint Inc WLP.N, largely opposed Obama's reforms but say the individual mandate is critical so additional customers can offset greater industry costs.
Breakingviews-More hurdles ahead [ID:nN1398869]
Factbox-Challenges to healthcare law [ID:nN13192163]
Graphic-Healthcare industry r.reuters.com/daj89q
Insider-Court ruling link.reuters.com/vyg89q
Insider-Obama setback link.reuters.com/fug69q
Health insurers' stock prices initially rose on the ruling before later tapering off as investors saw more uncertainty as the case proceeds. The ruling signaled that changes to the bill rather than a full overhaul are more realistic.
"Investors are taking this in stride knowing this is probably going to come down to the Supreme Court sooner or later," said Morningstar analyst Matthew Coffina. "This really only adds to that uncertainty in terms of not really being sure if and when and how the legislation can be implemented."
Virginia's lawyers argued that the federal government could not regulate someone for not buying a good or service under the U.S. Constitution's Commerce Clause and could not penalize them for failing to buy health insurance.
SLIM CHANCE OF FULL REPEAL
"This lawsuit is not about healthcare. It's about liberty," said Virginia Attorney General Ken Cuccinelli. He said he had discussed with the Justice Department ways to accelerate the appeals process to try to minimize uncertainty in the states and in the industry.
Representative Eric Cantor, set to become majority leader in the House of Representatives, called for sending the case immediately to the Supreme Court. He said he would push the House to pass a repeal of the law next year.
However, chances of a repeal are slim because Democrats will still control the Senate.
The White House said the law will ultimately be upheld by the legal system. It could take more than a year for the case to get to the Supreme Court.
Officials said the administration will keep implementing the rest of the law while it works through the legal questions of the individual mandate. Virginia had requested an injunction to block implementation of the entire law, but the judge did not grant it.
The decision is the first finding against the law, which was passed in March and is aimed at overhauling the $2.5 trillion U.S. healthcare system.
The Obama administration says Virginia does not have the legal standing to challenge the law on behalf of its citizens, particularly for something that has yet to take effect.
Two judges have rejected other challenges to the law, including one in Virginia last month. Justice Department lawyers will argue another lawsuit filed by 20 states in Florida later this week.
Outgoing Minnesota Governor Tim Pawlenty, often mentioned as a Republican contender for president in 2012, said the law gave the U.S. government too much power over states.
"While today's ruling is a victory for individuals' rights, I'm also hopeful that courts will recognize that Obamacare is also a threat to states' rights," he said in a statement, using the nickname critics use for the reform law.
The individual coverage mandate was considered a key guarantee in the plan for keeping health insurance premiums low, because it ensures that healthy as well as sick people will buy insurance.
If the lawsuit succeeds, "millions of Americans will lose their health insurance, premiums will go up for working families, and more people will be forced into bankruptcy when they get sick," said Representative Pete Stark, a Democrat who chairs the House of Representatives Health Subcommittee. (Additional reporting by Susan Heavey, Matt Spetalnick, Steve Holland, Rick Cowan and Lewis Krauskopf in New York; editing by Todd Eastham and Chris Wilson)