By Sarah Young and Kylie MacLellan
LONDON (Reuters) - Britain's pro-European Union Liberal Democrat party won a parliamentary seat previously held by the ruling Conservatives on Friday in a major upset it hailed as a rejection of a "hard Brexit" that would pull the country out of the single market.
Liberal Democrat Sarah Olney's victory in a constituency in southwest London - overturning the Conservatives' 23,000 majority from 2015 - illustrated the deep divisions running through a country that voted 52-48 percent to leave the EU.
It also reduces Prime Minister Theresa May's already slim majority in parliament, which might have to approve her decision to trigger the formal process of withdrawing from the bloc.
The affluent Richmond Park and North Kingston area had backed the Remain camp in June's referendum on EU membership.
Olney, who had campaigned for the parliamentary seat on a promise to vote against triggering the withdrawal talks, said its residents had sent "a shockwave" through the Brexit process.
"Our message is clear: we do not want a hard Brexit; we do not want to be pulled out of the single market; and we will not let intolerance, division and fear win," she said in a speech after her victory was announced.
She beat the incumbent Zac Goldsmith with 20,510 votes to his 18,638. Goldsmith ran as an independent candidate after quitting the Conservatives over the government's decision to expand nearby Heathrow Airport. [nL8N1CV7MK]
All the main candidates in Richmond opposed Heathrow expansion, however, and the Liberal Democrats turned the by-election into a vote on the terms of Brexit.
Goldsmith, the son of a billionaire financier, was a longstanding supporter of Brexit.
May's Conservatives, which did not field a candidate to oppose Goldsmith, said the result did not change anything in terms of Britain's Brexit strategy and invoking Article 50 of the EU's Lisbon Treaty to begin the withdrawal process.
"The government remains committed to leaving the European Union and triggering Article 50 by the end of March next year," a Conservative spokesman said on Friday.
Since the June 23 vote to leave the EU - which was driven in part by a desire to curb immigration from the bloc - investors have been watching closely for any signs of the approach that the government will take in the trade-off between securing single market access and accepting some free movement of people.
A speech made by May in early October, which suggested she would take a hardline approach to the negotiations and prioritize border controls in a "hard Brexit", added to losses for sterling since the referendum.
The pound has gained in recent days however on signs that the government might be softening its stance and seek to retain some access to the single market. It has also been boosted by a court ruling that parliament must vote on whether to trigger the divorce talks as investors believe lawmakers will seek to avoid a "hard Brexit".
The government will appeal the ruling in the Supreme Court next week. [nL8N1DT1Y4]
The Liberal Democrats, the junior partner in a coalition government with the Conservatives for five years before they were crushed at the 2015 general election, have said they want a second referendum on the terms of the Brexit deal.
"What this by-election shows is that it's a warning to all political parties as to potentially how disruptive this Brexit process is going to be for the regular practice of party politics," polling expert John Curtice told the BBC.
"It is the impact of Brexit on our domestic party politics that is why this by-election matters."
The Liberal Democrats held Richmond Park for 13 years until 2010. Their victory follows a strong second-place result for the party in an October by-election for a constituency vacated by former Prime Minister David Cameron. [nL8N1CR16G]
May's Conservatives face another by-election on Dec. 8, after one of their lawmakers, Stephen Phillips, resigned in November citing "irreconcilable policy differences" with the government. [nL8N1D53PC]
(Writing by Sarah Young and Kate Holton; Editing by Pravin Char)