* Feuding groups are to complete talks in 60 days
* Neighbours concerned conflict could spread
By Aaron Maasho
ADDIS ABABA, June 11 (Reuters) - East African states threatened on Tuesday to slap South Sudan's warring sides with sanctions unless they cease all military operations in a conflict which has sparked fears that it could spiral into genocide.
South Sudan's government and rebels, locked in heavy fighting since mid-December, signed a second ceasefire agreement in May after a previous deal failed to hold.
But government forces backing President Salva Kiir and soldiers loyal to his sacked deputy Riek Machar violated the ceasefire hours after it took effect, with the continued bloodshed compounding the worsening humanitarian crisis in the world's youngest country.
Fighting has already killed thousands of people and driven more than 1.3 million from their homes. The United Nations has warned that 4 million people could be on the brink of starvation by the end of the year because violence had disrupted the planting season.
On Tuesday, leaders from the Intergovernmental Agency for Development (IGAD) - the East African bloc brokering peace talks - held discussions with both Kiir and Machar to push for an end to fighting ahead of negotiations on the formation of a transitional government.
"They (Kiir and Machar) agreed fully to commit themselves to the already signed agreements and to complete all negotiations within the coming 60 days and then establish a transitional government of national unity," Ethiopian Prime Minister Hailemariam Desalegn told reporters after the meeting late on Tuesday.
"If they don't abide to this agreement, IGAD as an organisation will act to implement peace in South Sudan. On that, we have different options including sanctions and (other) punitive actions as well," added Hailemariam, who is also current chair of the bloc.
It is the first time that South Sudan's neighbours have issued such a warning, indicating growing frustration in a region increasingly concerned that the unrest may escalate into a broader regional conflict.
Washington has already imposed measures. The U.S. Treasury Department sanctioned Peter Gadet, an army commander loyal to Machar, and Major-General Marial Chanuong, head of Kiir's presidential guard.
The designation freezes any of their assets in the United States and blocks American nationals or companies from dealing with them.
Fears of a descent into genocide grew after the United Nations said the rebels had massacred hundreds of civilians in Bentiu in April. Residents of Bor, a predominantly Dinka town, attacked members of the Nuer ethnic group camped in a U.N. base soon afterwards.
Oil output, South Sudan's economic lifeline, has been cut by a third to about 160,000 barrels per day since fighting began.
The U.N. peacekeeping department has had to boost the number of troops and police and alter its mandate to make protecting civilians a top priority for the U.N. mission in South Sudan, known as UNMISS.
Last month, U.N. peacekeeping chief Herve Ladsous said China planned to send a battalion of troops to join UNMISS, along with additional soldiers from Rwanda, Ethiopia and Kenya, who are expected to join the mission.
Fighting erupted in South Sudan in December after months of tensions sparked by Kiir's decision to fire longtime rival Machar from his post as deputy president. Deep ethnic divisions also have fuelled the violence, pitting Kiir's Dinka people against Machar's Nuer group. (Editing by George Obulutsa and Eric Walsh)