* Merkel won't budge on refugee issue despite historic defeat
* Her Bavaria sister party demands upper limit on refugees
* German chancellor accepts blame for state election loss
* Questions arise about her re-election prospects in 2017
By Erik Kirschbaum
BERLIN, Sept 5 (Reuters) - German Chancellor Angela Merkel acknowledged on Monday that her pro-refugee policies led to her party's state election rout on Sunday but said they would not be jettisoned even though her Bavarian ally is clamouring for change.
In a rare, self-critical reflection over a state election defeat, Merkel insisted three times in the space of a four-minute statement in China that her decision to open the gate for refugees last year was right and would not be changed.
"I'm also responsible, obviously," Merkel said, breaking her rule against speaking on domestic issues while outside Germany as she was on a visit to China. "But I believe the fundamental decisions made in the past months are the right decisions."
The poor showing of Merkel's Christian Democratic (CDU) party in the Mecklenburg-Vorpommern state vote has raised questions about her hopes of winning - or even running - for a fourth term in the 2017 general election.
Her refusal to change course on refugees deepened a split with the arch-conservative Christian Social Union (CSU), the Bavarian sister party of the CDU. After Sunday's vote, CSU leaders quickly renewed an internecine battle with calls for limits on refugees.
The CDU suffered one of its worst electoral defeats when it fell to third place in Mecklenburg-Vorpommern behind the centre-left Social Democrats and anti-immigrant Alternative for Germany (AfD).
"I'm extremely dissatisfied with the election result," she said, noting refugees had overwhelmed local issues in the rural northeastern state that has been her home district since 1990.
It was the first time the CDU lost to a far-right party in a state election, winning a paltry 19 percent, according to preliminary final results. The SPD won with 30.6 percent while the AfD scored a historic win over the CDU with 20.8 percent.
The AfD played on the public's angst that refugees, some 70 percent of whom are Muslims, are overrunning Germany, siphoning away housing, resources and jobs from Germans. Merkel rejected that argument, saying no funds were taken away for refugees.
GERMANS ON EDGE AFTER ATTACKS
Fears of terrorism run high among AfD supporters after two refugees carried out Islamic State-inspired attacks in July.
"Everyone's got a lot of thinking to do about winning voters back, and that means first of all me, of course," said Merkel, who has won the last three federal elections since 2005 but has had to delay her announcement of a run for a fourth term because of CSU opposition, according to Der Spiegel newsmagazine.
Her approval ratings fell 22 points to a five-year low at 45 percent in the year since she opened the gates to more than a million refugees, mainly from Syria, Iraq and Afghanistan, drawn by Germany's famed prosperity, order and stability.
The CSU has been railing against Merkel's steadfast opposition to putting limits on the number of refugees even though Germany took in more than the rest of Europe combined in 2015. Incoming refugee numbers have dropped sharply this year.
There have been rumours that the powerful CSU leader, Bavaria state premier Horst Seehofer, is considering a run for chancellor in 2017 instead of supporting Merkel's candidacy. That threat had always been thwarted in the past by CDU warnings that it would then run its own campaign in Bavaria.
"We need a change of direction in Berlin," Bavarian state Finance Minister Markus Soeder told the Bild daily. "The voice of the people can't be ignored any longer."
CSU General Secretary Andreas Scheuer, Seehofer's right-hand man, demanded Merkel drop her opposition to limits on refugees. "It's obvious who's to blame for this election - not the CSU."
Grumbling in CDU ranks is also growing as many fear a drubbing in next year's federal election would cost it dozens of seats in parliament. The CDU/CSU has slid some eight points to 33 percent in the last year, Infratest Dimap said last week.
"Peoples' confidence in the chancellor has been badly shaken," said Erika Steinbach, a CDU MP. "It's hard to tell if that can be repaired by the election." (Editing by Andrea Shalal and Mark Heinrich)
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