* Government says fighting continues in Malakal
* First attack on major town since ceasefire deal
* Upper Nile is country's main oil producing state
* Uganda could remove troops within two months
By Carl Odera
JUBA, Feb 18 (Reuters) - South Sudanese rebels said they had seized control of the capital of oil-producing Upper Nile state on Tuesday, an assault that the government said breached a ceasefire and which casts doubt over planned peace talks.
The rebel strike was the first attack on a major town since the Jan. 23 ceasefire deal, but the government denied rebels now controlled Malakal, which lies on the fringes of a key oil-producing area in the country's northeastern corner.
The factions are under strong international pressure to lay down arms and start a delayed second round of talks, although diplomats question the commitment of either side to end the conflict as each has blamed the other for ceasefire violations.
"There is little sign on either side of a real intention to sit down and negotiate seriously," one Western diplomat said.
The clashes will fuel concerns over the security of South Sudan's northern oil fields - an economic lifeline for Juba and neighbouring Sudan, which receives a fee from the south for crude piped across its territory to the coast for export.
The rebels struck Malakal, located 650 km (400 miles) north of the capital Juba, shortly after daybreak. Their commander, Gathoth Gatkuoth, a close ally of former vice president Riek Machar, told Reuters they swiftly captured the town.
But a spokesman for government SPLA forces said later that fighting continued in Malakal's southern neighbourhoods and that communications with the town had been lost.
Both camps have repeatedly accused the other of breaking the ceasefire. South Sudan on Tuesday voiced frustration at the lack of progress made by mediators to deploy regional observers to flashpoint areas.
"It is a flagrant violation of the cessation of hostilities agreement signed by both sides," South Sudan's Information Minister Michael Makuei told Reuters. "We have been calling on the envoys to expedite the establishment of the monitoring mechanism but nothing has happened so far."
Malakal lies about 140 km (90 miles) from Paloch, an oil complex where a key crude oil processing facility is situated.
South Sudan says it has already been forced to cut oil production by a fifth to 200,000 barrels per day, all of which is pumped from Upper Nile. Rebel control of Malakal could raise concerns over its ability to maintain the rate of output.
"All the oil from the fields around Upper Nile is pumped to Paloch," said Jacob Jok Dut, director of the Centre for Democracy and International Analysis who follows the oil industry closely. "If Malakal comes under rebel control, then definitely there will be tension in and around Upper Nile."
PEACE TALKS FLOUNDER
Oil accounts for 98 percent of government revenues. Oil firms in South Sudan, a country the size of France, include China National Petroleum Corp, India's ONGC Videsh and Malaysia's Petronas. Work in some fields has been suspended.
Thousands of people have been killed and more than 800,000 have fled their homes since fighting began two months ago, triggered by a power struggle between President Kiir and Machar, his former deputy whom he sacked in July.
Situated on the banks of the White Nile, Malakal has changed hands several times. The latest rebel move may be aimed at strengthening its hand before further peace talks.
U.N. spokesman in South Sudan, Joe Contreras, said a U.N. camp in Malakal, where many of the displaced people had fled for protection, had been caught in the crossfire.
Peace talks had been due to resume last week, but were held up by a rebel demand that four remaining political prisoners held by the government be released and the Ugandan military, which is supporting Kiir's army, withdraw from South Sudan.
Uganda's Ministry of Foreign Affairs said on Tuesday that Ugandan troops could pull out, or redeploy away from flashpoint towns, within two months if other African nations provided troops in that time, a scenario analysts say is unlikely.
"What we don't want is to leave a security vacuum," Fred Opolot, a foreign ministry spokesman, told Reuters.