* Ten-year deal includes major Israeli concessions
* Both sides aimed for agreement before Obama leaves office
* Israel originally sought upwards of $4.5 billion a year (Adds Graham reaction)
By Matt Spetalnick and Patricia Zengerle
WASHINGTON, Sept 13 (Reuters) - The United States and Israel have agreed on a record $38 billion package of U.S. military aid and will sign the new pact on Wednesday, enshrining defense funding for Washington's closest Middle East ally for the next decade, officials said.
The deal will represent the biggest pledge of U.S. military assistance made to any country but also involves major concessions granted by Israeli Prime Minister Benjamin Netanyahu, according to officials on both sides and U.S. congressional aides.
Those include Israel's agreement not to seek additional funds from Congress beyond what will be guaranteed annually in the new package, and to phase out a special arrangement that has allowed Israel to spend part of its U.S. aid on its own defense industry instead of on American-made weapons, the officials said.
Israel's chief negotiator, Jacob Nagel, acting head of Netanyahu's national security council, arrived in Washington in preparation for the signing ceremony, and the White House also began briefing members of Congress on the deal.
Nearly 10 months of drawn-out aid negotiations have underscored continuing friction between President Barack Obama and Netanyahu over last year's U.S.-led nuclear deal with Israel's arch-foe Iran, an accord the Israeli leader opposed. The United States and Israel have also been at odds over the Palestinians.
But the right-wing Israeli premier decided it would be best to forge a new arrangement with Obama, who leaves office in January, rather than hoping for better terms from the next U.S. administration, according to officials on both sides.
A deal now allows him to avoid uncertainties surrounding the next president, whether Democrat Hillary Clinton or Republican Donald Trump, and to give Israel's defense establishment the ability to plan ahead.
Obama's aides want a new deal before his presidency ends, seeing it as an important part of his legacy. Republican critics accuse him of not being attentive enough to Israel's security, which the White House strongly denies, and of taking too hard of a line with the Israeli leader.
Israel has long been a major recipient of U.S. aid, mostly in the form of military assistance against a backdrop of an ebbing and flowing conflict with the Palestinians and Israel's neighbors, as well as threats from Iran.
The 10-year aid packages underpin Washington's congressionally mandated requirement to help maintain Israel's "qualitative military edge" in the region.
Despite increased funding under the new package, Republican U.S. Senator Lindsey Graham, a key pro-Israel lawmaker, said that while the agreement was "deserving of respect," it was too restrictive and not generous enough to meet Israel's needs. Efforts to finalize the deal had been held up over his objections, sources familiar with the matter said.
The deal, known as a memorandum of understanding, or MOU, calls for $3.8 billion a year in aid, up from $3.1 billion annually under the current pact, which expires in 2018, officials say. Netanyahu had originally sought upwards of $4.5 billion a year.
The new package for the first time will incorporate money for Israeli missile defense - setting the amount at $500 million a year - which until now has been funded ad hoc by Congress. U.S. lawmakers have in recent years given Israel up to $600 million in annual discretionary funds for this purpose.
Officials say Israel has agreed not to lobby Congress for additional missile defense funds during the life of the new MOU, a pledge expected to be made in a side letter or annex to the agreement. But the wording is likely to be flexible enough to allow exceptions in case of a war or other major crisis.
The State Department and Netanyahu's office coordinated the release of brief Statements declaring the deal was complete and would be signed at a ceremony in Washington on Wednesday. Neither side offered details.
The pact will not be signed by Obama and Netanyahu, who have had a fraught relationship, but by two senior aides, in keeping with the way the two governments have formally sealed previous deals of this type. Nagel and U.S. Undersecretary of State for Political Affairs Thomas Shannon will sign the document.
Netanyahu gave ground on several major points. He conceded to a U.S. demand for a gradual phasing-out, starting in 2020, of the 26.3 percent share of the aid money that Israel can spend on its own military industries rather than on American products. The provision originated in the 1980s to help Israel build up its defense industry, which is now a major global player. The issue was a major sticking point in negotiations.
Netanyahu also agreed to end Israel's use of 13 percent of the U.S. money on military fuel purchases, officials said.
Obama and Netanyahu will both be in New York next week for the opening of the U.N. General Assembly, and officials have not ruled out the possibility of a meeting on the sidelines.
U.S. congressional approval is needed each year for disbursement of the aid to Israel as part of the annual budget process. While Graham insisted the MOU would not be "binding on future Congresses," reaction was mostly positive on Capitol Hill, where support for Israel's security is strong. (Additional reporting by Luke Baker in Jerusalem; Editing by Alison Williams and James Dalgleish)
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