By Jim Christie

STOCKTON, California (Reuters) - Stockton, California will become the largest U.S. city to seek protection from its creditors after its leaders approved a budget on Tuesday night based on the city filing for bankruptcy.

A Chapter 9 bankruptcy by the city of nearly 300,000 in California's Central Valley, about 85 miles east of San Francisco, could come as early as Wednesday.

Stockton's city council voted six to one in favor of the 2012-2013 budget after a contentious five-hour meeting where angry retired city workers pressed council members to reject the $155 million spending plan. It proposes eliminating retirees' medical benefits to help fill a $26 million budget deficit.

Retired police department employee Geri Ridge said she fears not being able to afford health-care insurance.

"I don't have that kind of income," said Ridge, 56, noting she is concerned a large share of her $1,895 monthly pension payment could be consumed by large insurance costs due to her history of heart attacks.

The council's vote followed three months of confidential talks between Stockton and its creditors aimed at averting bankruptcy. The negotiations ended on Monday with the city failing to win enough concessions to help close its shortfall for the fiscal year starting on July 1.

That left bankruptcy as the only way for Stockton to balance its budget in the near term while maintaining its current level of services and bringing stability to its battered finances, Mayor Ann Johnston said.

"It's heart-wrenching to think about the implications," she said. "I see no other solution."

Stockton officials have said since February their city's finances are suffering the combined effects of fiscal mismanagement over two decades, too much debt taken on in good times and generous pay and unsustainable benefits for city employees and retirees.

Stockton has also suffered a sharp drop in revenue since the collapse of its once red-hot housing market. The housing boom transformed the farming city into a distant bedroom community of the San Francisco Bay area and its bust put Stockton at or near the top of national foreclosure rankings in recent years.

To keep its budget in balance, Stockton has cut more than $90 million in spending in recent years and slashed its work force, including a quarter of its police officers, a pressing concern with a surge in violent crime in the city.

Deeper cuts to police payrolls would be intolerable, making a financial restructuring in bankruptcy a necessary if painful choice, according to council members who voted for the budget.

The $3.7 trillion U.S. municipal bond market has so far taken in stride Stockton's march toward bankruptcy despite the city's more than $700 million in bond debt. Bondholders and bond insurers are among Stockton's 18 creditors.

LANDMARK FOR U.S. MUNICIPAL DEBT MARKET

Because municipal bankruptcies under Chapter 9 of the federal bankruptcy code are rare, especially for larger cities, Stockton could set important precedents for how different types of creditors are treated in such cases.

In the past, large cities such as Bridgeport, Connecticut, have seen filings for bankruptcy protection rejected by the court. In the most recent case in October 2011, a filing by Harrisburg, Pennsylvania, a city of nearly 50,000, was rejected because a state law barred municipalities of a certain size from seeking legal protection from creditors.

Lawyers representing Stockton also worked for Vallejo, California when it filed for bankruptcy in 2008. The former Navy town emerged last year from bankruptcy with sharply reduced payments for its retiree medical program.

At $4.23 billion, Alabama's Jefferson County last November set the record for the biggest municipal bankruptcy filing, which is still working its way through the court.

Stockton officials have been considering bankruptcy since February and calling for the kind of drastic action in its budget. It suspends $10.2 million in debt payments, a move likely to trigger further downgrades of Stockton by ratings agencies.

Stockton has already defaulted on about $2 million in debt since February, allowing the trustee for one of its bond insurers to seize a building once slated to be its future city hall and three parking garages.

The intentional default prompted Moody's Investors Service and Standard & Poor's Ratings Services to drop their credit ratings on Stockton. Moody's has cut its issuer rating for Stockton to a junk level Ba2 from Baa1 while S&P has cut its issuer rating on the city from BB to SD, one notch above its D default rating.

Stockton's budget would also cut spending on employee compensation and retiree benefits by $11.2 million. About $7 million in savings would come from cutting retiree medical benefits for one year and then phasing them out, an idea that stuns John Skaff, a retired police officer.

Skaff said knee injuries forced him off Stockton's police department after 19 years there and he expects to need knee-replacement surgery, though he is uncertain how to afford it without his health coverage. "It's a big hit for us," he said.

(Reporting by Jim Christie, Editing by Tiziana Barghini, Lisa Shumaker, Tim Pearce)