By Alistair Lyon
JERUSALEM (Reuters) - Benjamin Netanyahu set about forging a new ruling coalition on Wednesday after Israeli voters fed up with state coddling of ultra-Orthodox Jews chastised him by propelling an upstart centrist party to prominence.
Tuesday's vote crystallized demands for attention to bread-and-butter issues over the ambitions of religiously fired hardliners, and largely sidelined foreign policy issues such as Iran's nuclear plans and Palestinian aspirations.
The right-wing prime minister claimed victory after his Likud party and its ultranationalist Yisrael Beitenu ally took 31 of parliament's 120 seats, according to a near-final tally.
That made it the biggest single bloc, despite losing 11 of its previous seats. Overall, right-wing factions emerged with roughly half the total. Final results are expected on Thursday.
Making a virtue of necessity, a weakened Netanyahu has signaled a desire to broaden his coalition with centre-left parties that would lend it a more moderate gloss.
Such a shift could ease friction between him and U.S. President Barack Obama, himself embarking this week on a new term in office and who wants to avert an Israeli attack on Iran and restart stalled peace talks with the Palestinians.
"The likelihood of a purely right-wing government has receded, along with the headaches that would cause for Obama," said David Makovsky, an expert at the Washington Institute for Near East Policy. "So there's a better chance for Netanyahu to find a ‘modus vivendi' with the U.S."
Israeli media highlighted the electoral setback for Netanyahu and the surprise surge of the centrist Yesh Atid (There is a Future) party, runner-up with 19 projected seats in a parliament likely to include about a dozen parties in all.
"SHARING THE BURDEN"
Yesh Atid and the centre-left Labour party, which came third with 15 seats, tapped into secular middle-class resentment that taxpayers must shoulder what they see as the burden of welfare-dependent ultra-Orthodox Jews exempt from military conscription.
Netanyahu, who in two terms as premier has enjoyed backing from the growing religious minority, quickly made overtures to his opponents by saying he wanted to form as wide a coalition as possible, a process that is likely to take several weeks.
In an apparent bid to persuade Yesh Atid leader Yair Lapid to join his cabinet, Netanyahu pledged his administration would ensure "a more equal sharing of the burden" - a reference to generous privileges granted to the ultra-Orthodox 10 percent.
Listing other priorities that he said he had agreed with his hardline ally and former foreign minister Avigdor Lieberman, he promised affordable housing and changes in the electoral system.
Lapid has focused his campaign on ending military draft exemptions for Jewish seminary students and drawing more of the ultra-Orthodox, many of whom receive state stipends, into the workforce - steps supported by many secular Israelis.
"We awaken to a morning after the elections with a clear message from the public, which wants me to continue to lead the country," Netanyahu told reporters summoned to his office.
A senior member of Yesh Atid said that ending exemption from military service was central to the party's platform, as was reviving U.S.-backed peace talks with the Palestinians.
"Whoever wants Yesh Atid in the coalition will need to bring these things," Ofer Shelah told Army Radio.
Palestinians reacted warily to the outcome of the poll, voicing doubts it would produce a government more willing to compromise for peace, even if it included centrist parties.
An editorial in the Palestinian daily Al-Quds said such parties would provide a "cosmetic decoration" for a Netanyahu-led government that would mislead world public opinion without halting a drive to expand Jewish settlement on occupied land.
IRAN IN HIS SIGHTS
"We're not seeking to make peace with this or that party in Israel," said Palestinian negotiator Saeb Erekat, adding that peace required creation of a Palestinian state to live alongside Israel based on the lines that existed before the 1967 war.
Netanyahu has complained that Palestinians' own divisions and the violence of some groups undermine attempts to talk.
He has unsettled Israel's Western friends, including Obama, with threats to attack Iran and a tough approach to the Palestinians: "The first challenge was and remains preventing Iran from obtaining nuclear weapons," Netanyahu said in an initial speech claiming victory overnight.
Iran denies it is planning to build an atomic bomb, and says that Israel, widely believed to have the only nuclear arsenal in the Middle East, is the biggest threat to the region.
Few in the region expect the election to change much: "It does not move the state of Israel closer to any sort of pragmatic government that Arab states can work with," said Michael Stephens at the Royal United Services Institute in Doha.
"There is too much baggage and little goodwill toward (Netanyahu) for the pendulum to swing towards a more favorable view of Israel anytime soon."
Israeli financial markets gained on Wednesday on investor hopes that Netanyahu will remain prime minister and exclude from his coalition ultra-Orthodox parties which have long demanded budget-draining state subsidies in return for political support.
The blue-chip Tel Aviv 25 stocks index closed one percent higher at 1,204.65 points.
Israel posted a budget deficit of 4.2 percent of GDP last year, more than twice the target, meaning the next government will probably have to impose tax increases and spending cuts.
Amram Mitzna, a senior member of former foreign minister Tzipi Livni's centrist Hatnua party, told Army Radio the election had "arrested the rightward drift of Israeli society".
He mooted an unlikely "dream government" in which Likud would forge a strong coalition with leftist and centrist parties, leaving far-right and religious factions in the cold.
But Naftali Bennett, high-tech millionaire son of American immigrants who leads the hard-right, pro-settler Jewish Home party, remains a likely coalition partner despite making a poorer election showing than opinion polls had predicted.
Bennett, who advocates annexing West Bank land to Israel, told cheering supporters: "There is only one truth and it is simple. The land of Israel belongs to the people of Israel."
U.S.-brokered peace talks broke down in 2010 amid mutual acrimony. Since then Israel has accelerated construction in the West Bank and east Jerusalem - land the Palestinians want for their future state - much to the anger of Western partners.
Tuesday's vote was the first in Israel since Arab uprisings swept the region two years ago, reshaping the Middle East.
Netanyahu has said the turbulence, which has brought Islamists to power in neighboring Egypt and elsewhere, shows the importance of strengthening national security.
(Reporting by Jerusalem bureau; and Matt Spetalnick in Washington; Editing by Alastair Macdonald)