BAGHDAD, Sun 31 October, 2004 (Reuters) - Iraq's interim Prime Minister Iyad Allawi says a showdown is imminent in the western city of Falluja, where U.S. marines are poised to assault insurgents and Islamist militants.

He said the government was still offering an olive branch, but told a news conference: "Our patience is running thin."

The government says Saddam Hussein loyalists and militants loyal to al Qaeda ally Abu Musab al-Zarqawi are operating from Falluja and Ramadi, another rebel city west of Baghdad.

The commander of a marine battalion near Falluja told reporters on Sunday his men were awaiting orders to attack.

"We will continue to probe the enemy's defence until such time as we decide to enter and clear the city," Lieutenant Colonel Willy Buhl said. "And we'll do that when Prime Minister Allawi and President (George W.) Bush tell us it's time to go."

The aim is to crush Iraqi guerrillas and foreign militants in Falluja and elsewhere before national elections in January.

Asked about on-off peace talks with Falluja notables, Allawi said: "We have no negotiations with Falluja because Falluja is part of Iraq. We want to free this town from the grip of terrorists who came from abroad."

The government has repeatedly demanded that the people of Falluja hand over Zarqawi militants and accept the return of Iraqi security forces or face military action.

"If there is a failure in doing this peacefully, then we will do it by force," he said. "We have to restore stability in Iraq ... The window for such a peaceful settlement is closing."

Allawi said there could be no compromise with fighters loyal to Zarqawi, Saddam Hussein or Osama bin Laden.

Allawi said authorities had arrested 167 Islamist militants in the past few weeks, most of them non-Iraqi Arabs.

Allawi said a "few thousand" followers of Saddam's former deputy president Izzat Ibrahim had also been detained in the past few weeks, among them two of Ibrahim's top aides.

JAPANESE HOSTAGE BEHEADED

Lieutenant Colonel Buhl, speaking before Allawi's latest comments, said the prime minister's stance made military action likely.

"If I were a betting man I would say, just from the prime minister's announcement, that the city has had a chance and that it's going to have to answer for its behaviour."

He said Zarqawi was probably "in and out of Falluja depending on the day" and added: "I don't think he'll be foolish enough to be there if we come in, but you never know."

Zarqawi's militants have claimed responsibility for some of Iraq's bloodiest suicide bombings and hostage decapitations.

The beheaded body of a Japanese man held by Zarqawi's group was found in Baghdad on Saturday night, capping a day that saw the highest U.S. death toll for months and the bloodiest attack on a media organisation since the start of the war.

Nine U.S. marines were killed on Saturday and a bomb attack on an Arab television station claimed seven lives in Baghdad.

Japanese officials confirmed the body and head found in the Iraqi capital were those of Shosei Koda, 24, a backpacker thought to have taken a bus to Iraq from Jordan last week.

"I once again feel anger at this cruel and inhuman act," said Japanese Prime Minister Junichiro Koizumi, a close Bush ally. He said Japan's 500 non-combat troops would stay in Iraq despite the killing.

Zarqawi's group had threatened on Tuesday to behead Koda within 48 hours unless Japanese troops went home.

About 25 foreigners from a dozen countries are believed held by kidnap groups in Iraq.

The wife of a Sri Lankan driver abducted in Iraq last week pleaded for his release. "He went there to work so that he can improve the life of the children and me," a sobbing Doria Rita Rajaratnam said of her husband Dinesh.

The body of a kidnapped Iraqi Kurdish journalist who was well-known in Saddam's era was found in Baghdad on Saturday. His wife said Nasrallah al-Dawoodi, 55, had disappeared on Wednesday. His kidnappers had demanded a big ransom.

Gunmen killed the driver of a Turkish fuel tanker on a highway north of Baghdad on Saturday night, police said.

Two Iraqi National Guards were killed when gunmen ambushed their car southeast of Baghdad, the Interior Ministry said.

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