* World powers and Iran meet in Baghdad for nuclear talks
* West hopes for outline of deal on curbing enrichment
* Sanctions relief for Iran a key question
By Justyna Pawlak and Patrick Markey
BAGHDAD, May 23 (Reuters) - World powers will test Iran's readiness under pressure of sanctions to scale back its nuclear programme at talks on Wednesday aimed at easing a decade-old standoff and averting the threat of a Middle East war.
The stakes could barely be higher: global oil markets are edgy over toughening sanctions on Iran's vital crude exports and the possibility of Israeli strikes against its defiant arch-foe, which has threatened reprisals if it comes under attack.
Wednesday's meeting between Iran and six world powers - the United States, Russia, China, Germany, France and Britain - will be the second since diplomacy resumed in mid-April in Istanbul after a 15-month hiatus that saw tensions soar.
Around 15,000 Iraqi police and troops will protect the venue inside the capital's heavily fortified Green Zone, which has been the target of attacks. Tehran's suggestion of a meeting in troubled Iraq, whose leadership is friendly to Iran, was seen by some diplomats as it testing Western commitment to seeking a deal. Formal talks are expected to start around noon (0900 GMT).
"Istanbul was important because for us. It was a test of the Iranians' willingness to engage. Baghdad should focus on concrete substance," a European diplomat said. "The ball is in their court. It is they who must make the first step."
One senior Western official said the six, led by EU foreign policy chief Catherine Ashton, would make Iran "a detailed proposal that will include confidence-building measures". No details were available, however, on what these would be.
The main goal of the six powers - known as the P5+1 for the five permanent U.N. Security Council members plus Germany - is expected to be an Iranian agreement to shut down the higher-grade uranium enrichment that it launched in 2010 and has since expanded in an underground plant at Fordow that, to Israeli alarm, would be largely impervious to attack from the air.
Producing such highly enriched material in such quantities has shortened the time Iran might need to build an atomic bomb.
Iran says its nuclear programme is a peaceful bid to generate electricity and has repeatedly ruled out suspending all its enrichment of uranium, an activity which can have both civilian and military purposes.
But it has indicated possible flexibility on the higher-grade enrichment of uranium to a fissile concentration of 20 percent, the part of Iran's work that most worries the West.
INSPECTION DEAL "CLOSE"
In a possible sign of a new Iranian willingness to address concerns about its atomic ambitions, the U.N. nuclear supervisor said on Tuesday he expected to sign a deal soon to unblock an investigation into suspected work on atom bombs.
But Western diplomats will be wary of past failures to carry out extra inspection deals between the International Atomic Energy Agency and Iran, and their patience is wearing thin.
They want Iran to cease work at the Fordow site and export its stockpile of higher-grade uranium - demands that analysts say Tehran would be unlikely to accept while sanctions remain.
"The key issue is the 20-percent enrichment potential. This has to be addressed in order to have a productive outcome," said one Western diplomat.
"The marching orders for Baghdad are to have concrete ideas on the table, maybe not necessarily agree on all details of these ideas, but to have a clear commitment."
Iran maintains that it needs uranium refined to a fissile concentration of 20 percent for its medical isotope reactor. Enrichment to 5 percent of fissile purity is suitable for power plant fuel, while 90 percent constitutes fuel for bombs. The technical leap from 20 to 90 percent is easier than that to reach 20-percent purity from the lower levels around 5 percent.
Iran's chief negotiator Saeed Jalili arrived on Monday in Baghdad where he met Iraqi Prime Minister Nuri al-Maliki. Western delegations were due to arrive on Wednesday.
"The meeting may not produce any miracles," Iraqi Foreign Minister Hoshiyar Zebari told Reuters, adding: "The Iranians are coming with a positive attitude. This is what we are hearing from both sides. They are coming to move, not just to talk."
With violence from its long war waning and U.S. troops gone, Iraq's government has sought to present an Arab League Summit held last month in Baghdad and the Iran nuclear talks as a sign the OPEC country is returning to the regional diplomatic stage.
Maliki's alliance is close to fellow Shi'ite Muslims running Iran, but his government has also sought to balance relations with fellow Arab states in a region where non-Arab Iran and Sunni powers like Saudi Arabia are jostling for influence.
Insurgents tied to Sunni militant network al Qaeda launched a major string of attacks on Baghdad and other Iraqi cities just before the Arab League meeting, killing 52 people. But the run-up to the Iranian talks has been relatively quiet so far.
SANCTIONS, CARROTS AND STICKS
Ashton has said she hopes the Baghdad talks will form the basis for Tehran to eventually abandon its suspected nuclear weapons programme.
But diverging agendas stand in the way of a breakthrough.
Iran has suggested it will try to leverage its reported rapprochement with the IAEA into a deal in Baghdad to relax sanctions inflicting increasing damage to its economy, including a European Union oil embargo due to take effect in July.
But Western officials ruled out such a weighty concession so soon, even though their call for a "step-by-step" negotiating process is widely seen as a tacit admission that sanctions will have to be eased at some point.
"Sanctions are only going to be lifted if we have significant and genuine progress," one diplomat said.
Ali Larijani, Iran's influential parliament speaker, warned the West on Tuesday not to play "political games" in Baghdad based on "misconceptions" that Iran is after nuclear power to menace its neighbours and dominate the Middle East.
Emanuele Ottolenghi of the Washington think-tank Foundation for the Defense of Democracies said that some concessions from the West would be crucial: "Maybe the U.S. and the EU should agree to suspend measures of minor nature," he said.
"They don't want these negotiations to fail."
Israel, widely assumed to have the Middle East's only atomic arsenal, has made clear its scepticism about the chances for diplomacy to achieve a solution to the dispute.
Asked whether last-resort air strikes on Iran were still conceivable with apparent headway being made on the diplomatic track, Israeli Civil Defence Minister Matan said: "One shouldn't get confused for even a moment. Everything is on the table."
Clara O'Donnell, at Washington's Brookings Institution, said: "The likelihood of an Israeli military strike will remain lower while the talks are ongoing. But they are likely to keep talking about it, to keep up the pressure." (Additional reporting by Sebastian Moffett in Brussels, Fredrik Dahl in Vienna, William Maclean in Dubai, Andrew Quinn in Amman and Adrian Croft and Mark Heinrich in London; Editing by Alastair Macdonald)