* Diplomats worry about violence if peace talks crumble
* Israelis, Palestinians set to lose out financially
* Face risk of losing significant Western trade, aid
* Conflict may shift to international organisations
By Crispian Balmer
JERUSALEM, Jan 27 (Reuters) - Even as Palestinians and Israelis strive for an elusive peace deal to end their generations-old conflict, the two sides are preparing for failure.
While contours of an accord have been debated for years, the consequence of collapse could take many forms.
U.S. Secretary of State John Kerry has cautioned that a breakdown in the talks he has tirelessly promoted for the past six months might lead to a third Palestinian uprising.
The Palestinians say they are ready to shift their battle for an independent state on land Israel captured in the 1967 Middle East war to the International Criminal Court if the negotiations prove fruitless.
Israel, by contrast, is pinning its hopes on maintaining the status quo - using exhaustive security measures to manage what has become a low-grade, occasional conflict while continuing to expand settlements in the West Bank - but might activate unilateral moves of its own if dialogue peters out.
Whatever happens, both sides will suffer a financial fallout if they cannot find a way to divide the land they both claim, with the long-established model of a U.S.-driven peace process also likely to take a significant hit.
"If this attempt fails, do not expect the Americans to come back for more pain ... Not for a very long time," said a senior Western diplomat based in Tel Aviv who was not authorised to talk to the media and could not be named.
A handful of diplomats remain hopeful Kerry will defy the pessimists and secure at least a framework deal in the coming weeks to allow detailed talks to continue beyond the original nine-month deadline, which expires on April 29.
But, still far apart on so many core issues including borders, security, the right of return for Palestinian refugees and the future status of Jerusalem, many Palestinians and Israelis share the view that the talks are not going anywhere.
"The ongoing negotiations ... are headed for failure, and will not be extended one day after their expiration on April 29," said Mohammed Shtayyeh, who quit the Palestinian negotiating team last year in protest at a wave of Israeli announcements of new settlement-building in occupied territory.
BLAME GAME STARTED
Since talks started last July, Israel has unveiled plans to build some 5,349 new homes in the West Bank and East Jerusalem - land the Palestinians want for their future state.
The European Union's ambassador to Israel, Lars Faaborg-Andersen, has warned that this rapid expansion means Israel is likely to be blamed should the negotiations implode.
"I'm afraid that what will transpire is a situation in which Israel will find itself increasingly isolated," he said last week, adding that the settlements did not play "in a good way with the public and also the political class in Europe".
A Dutch pension fund said this month it was divesting from five Israeli banks because of their work in the settlements, while a large Dutch utility severed ties with Israel's national water company because of its West Bank activities.
Israelis fear EU displeasure could cost them dear, with their joint trade ties put at 30 billion euros ($41 billion).
"It could become unpleasant for us because the Europeans seem to be determined to blame Israel come-what-may," said Alan Baker, a former legal adviser to the Israeli Foreign Ministry and ex-ambassador to Canada.
"It won't be crippling, but from a publicity point of view it will have its own dynamic, which will be negative."
By the same token, the EU has warned the aid-dependent Palestinians it might reduce the one billion euros it hands them each year - crucial budget support for the Palestinian Authority in self-rule areas, if they snub Kerry's initiative.
The stakes would also be high if President Barack Obama's administration gets into the blame game - but any move to single out Israel would stoke anger in the staunchly pro-Israel U.S. Congress. This risk would mean the $3 billion a year in U.S. aid to the Jewish state is likely to be protected.
Israeli opposition leader Isaac Herzog, who heads the dovish Labour party, says the threat of EU economic curbs should persuade Prime Minister Benjamin Netanyahu of the need to make the hard concessions that peace would entail.
However, speaking to foreign reporters last week, Herzog said Israel should prepare a "plan B" in case of failure.
"In paintbrush mode, plan B can include certain steps that will encourage settlers to go back home, via legislation and other encouragement, (and) drafting a new map for further redeployments," he said, hinting at the possibility that Israel may one day unilaterally define its own borders.
This would be highly controversial and very unlikely in the short term. However, peace advocates say Israel must roll back its occupation of the West Bank, home to some 2.5 million Palestinians, if it wants to maintain its Zionist ideals.
"If talks fail, for Israel, the demographic dynamic will make it impossible to preserve its future as a democratic Jewish state," Kerry said in Davos last week, alluding in part to the strong Palestinian birthrate.
Pro-settlement groups claim historical and biblical links to the occupied land. They reject any peace accord that would oust any of the more than 500,000 settlers from their homes.
Faced by the growing influence of the settlers, some Palestinian officials in the West Bank talk of the need for a return to "resistance" after years of cooperation with Israel.
Tawfiq Tirawi, a senior member of Palestinian President Mahmoud Abbas's Fatah movement, told Lebanon's Mayadeen channel last week that Palestinians would not win independence even in 20 years and called for "resistance in all of its forms".
Asked to explain, he said: "Steadfastness is also resistance, negotiations are also a form of resistance, but there must be something on the ground as well ... weapons, popular resistance, there are hundreds of ways to resist."
Once unleashed, violence is hard to contain.
The breakdown of previous, U.S.-brokered peace talks in July 2000 is seen as a major factor behind the outbreak of the second Palestinian Intifada (uprising) just two months later. The revolt lasted more than four years, killing more than 4,000 Palestinians and 1,000 Israelis and wrecking the economy and infrastructure in Palestinian self-ruled cities and towns.
That conflict was widely perceived to have proven a disaster for the Palestinians, and Tirawi's call to arms does not resonate widely in Abbas's inner circle.
Instead, officials say they would look to fill the void left by a failed peace process with a concerted effort to join a plethora of international bodies from which they could harass Israel - including the International Criminal Court.
Palestinians have long threatened to go to the ICC and file charges saying that Israeli settlements constitute a war crime under the Fourth Geneva Convention.
It is far from clear whether the Hague-based court would accept such a suit, given that Palestine is not a full member of the United Nations. But Palestinians say it is vital to maintain some form of pressure on Israel, a militarily far superior adversary, if Kerry's mission disintegrates.
"The Palestinian leadership will go to the United Nations to prosecute Israel for its crimes in the event of the failure of the negotiations," said former negotiator Shtayyeh, adding that Abbas had made a mistake by not doing this much earlier.
"We have to correct this error," he said. (Editing by Mark Heinrich)
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