* Premier urged to resign too in spiralling crisis
* Graft inquiry pits government against judiciary
* Fresh demonstrations in biggest Turkish cities
By Orhan Coskun and Ece Toksabay
ANKARA/ISTANBUL, Dec 25 (Reuters) - Turkish Prime Minister Tayyip Erdogan reshuffled his cabinet on Wednesday after three members quit over a corruption scandal that has posed an unprecedented challenge to his 11-year rule.
The crisis erupted on Dec. 17 when dozens of people, including of the head of state-run Halkbank, were arrested on graft charges. Erdogan responded by purging police investigators. The ensuing feud with the judiciary reignited long-simmering street protests and rattled foreign investors.
Earlier on Wednesday, three ministers who had sons among those detained resigned. Two of them echoed Erdogan in depicting the inquiry as baseless and a conspiracy. The third, Environment Minister Erdogan Bayraktar, turned on the premier.
“For the sake of the wellbeing of this nation and country, I believe the prime minister should resign,” he told NTV news.
By breaking ranks, Bayraktar may have diluted any easing of pressure on Erdogan afforded by the ministers’ resignations, although some commentators thought their timing was off.
“These are very late and difficult resignations. They don’t have any value in terms of democracy,” said Koray Caliskan, an associate professor at Istanbul’s Bogazici University.
After nightfall, a spent-looking Erdogan announced he was appointing 10 new ministers to replace the three who quit and others planning mayoral runs in local elections in March.
The fact that the shake-up happened over Christmas cushioned the blow to Turkey on dormant international markets. But the stock index closed 4.2 percent and the lira weakened to 2.0862 against the dollar.
During his three terms in office, Erdogan has transformed Turkey by tackling its once-dominant secular military and overseen rapid economic expansion. He weathered anti-government demonstrations that swept Istanbul and other cities in mid-2013.
The gauntlet thrown down by Bayraktar set off fresh protests in Ankara, Istanbul and Izmir. Erdogan was unmoved.
In a speech earlier on Wednesday, he vowed no tolerance corruption. He argued that the work of the about 70 police investigators he had sacked or reassigned - including the chief of the force in Istanbul, Halkbank’s headquarters - was deeply tainted.
“If a verdict is made by the opposition party on the second day of the investigation, what’s the point of having judges? If a decision is made by the media, what’s the point of having these long legal procedures?” Erdogan said to provincial leaders of his Islamist-rooted AK party.
Alluding to TV news reports that have riveted Turks with footage of cash-filled shoe boxes allegedly seized at suspects’ homes, he asked: “How do you know what that money is for?”
The 14-month investigation was conducted largely in secret. At the weekend, the government changed regulations for the police, requiring officers to report evidence, investigations, arrests and complaints to commanding officers and prosecutors. Journalists have been banned from police stations.
The Hurriyet newspaper said up to 550 police officers, including senior commanders, had been dismissed nationwide in the past week by Interior Minister Muammer Guler, who has now resigned.
Erdogan’s critics see an authoritarian streak in his rule. The European Union, to which Turkey has long sought accession, on Tuesday urged Ankara to safeguard the separation of powers.
“The only way you can explain an interior minister removing the police chiefs working in an investigation regarding his own family is that the aim is to obstruct evidence,” said Caliskan, who writes for the centrist newspaper Radikal.
“The prime minister thinks Turkish people are not very clever (but) he will be slapped hard at the ballot box.”
Turkey’s next parliamentary election is not until 2015. But with the local ballots looming, pollsters say the scandal’s so-far modest erosion of AK’s popular support could quicken.
In a fourth resignation on Wednesday, AK lawmaker Idris Naim Sahin, a former interior minister, told the party he was also stepping down, according to sources in his office.
The scandal has laid bare rivalry between Erdogan and Fethullah Gulen, a U.S.-based Turkish cleric whose Hizmet (Service) movement claims at least 1 million followers, including senior police officers and judges, and which runs schools and charities across Turkey and abroad.
While denying any role in the affair, Gulen described Erdogan as suffering “decayed thinking” after the premier portrayed himself as fending off a shadowy international plot.
In an apparent reference to Gulen, Erdogan said on Wednesday: “We would not allow certain organisations acting under the guise of religion but being used as the tools of certain countries to carry out an operation on our country.”