By Tomasz Janowski and Stanley White
TOKYO (Reuters) - Japan talked tough on Friday in an emotional row with South Korea, with lawmakers calling on Seoul to end its "illegal occupation" of a disputed island chain, but the prime minister also called for calm and a diplomatic solution to the feud.
Tension between the North Asian countries, both close U.S. security allies, flared this month after President Lee Myung-bak became the first South Korean leader to set foot on the islands claimed by both countries.
Lee's visit and his call for Emperor Akihito to go beyond expressing "deepest regrets" for Japan's 1910-1945 colonial rule triggered a diplomatic tit-for-tat feud, and a rare veiled threat from Japan to flex its economic muscle.
The dispute between Japan and South Korea over the islands known as Dokdo in Korea and Takeshima in Japan has coincided with a standoff between Japan and China over another island chain that sparked anti-Japanese protests in China last week.
Japanese Prime Minister Yoshihiko Noda, accused by the opposition of being too soft on territorial disputes, walked a fine line, fending off criticism while trying to keep the disputes from spinning out of control.
"In order to protect our national interests, I will say what we must say and do what should be done," Noda told a news conference.
"On the other hand, it would do no good to any country if we uselessly fan hardline opinions at home and escalate the situation," he added. "The important thing is to seek a solution in peaceful and diplomatic ways."
But Noda also sharpened his rhetoric and, in a break with past practice, referred to South Korea's control of the islands as "illegal occupation".
"After the end of the war, South Korea started illegal occupation," Noda said, echoing the language of lawmakers who earlier passed a resolution condemning Lee's visit to the islands and demanding their return to Japan.
That spurred a swift rebuke from South Korea.
"We strongly protest the prime minister's unjust territorial claim to Dokdo which is historically, geographically and by international law our sovereign land ... and urge he immediately withdraw it," South Korean Foreign Ministry spokesman Cho Tai-young said in a statement.
Japan's lower house adopted a separate resolution criticizing last week's landing of Chinese activists on an island chain in the East China Sea claimed by both Japan and China.
That resolution drew a protest from China which said the islands it calls the Diaoyu, known as the Senkaku in Japan, "have been Chinese territory since ancient times".
"For Japan to seek to use this resolution to strengthen its position is unlawful and futile," said Chinese Foreign Ministry spokesman Hong Lei.
Noda said he had no specific economic steps in mind to take in the dispute with South Korea, but Finance Minister Jun Azumi earlier suggested that Tokyo might not extend a currency swap arrangement with South Korea after it expires in October.
He also said Japan was weighing a plan to buy South Korean government debt.
"Things have reached the point where the Japanese people may not be able to accept the argument that political relations and economic relations are separate," Azumi told reporters.
The Yomiuri newspaper reported that Japan was leaning towards aborting its plan to buy South Korean government bonds, saying the government believed it would not be understood by the public, given the diplomatic climate.
"WORK THIS OUT"
The United States called on Japan and South Korea to find a solution.
"Both of these countries are strong, important, valued allies of the United States," State Department spokeswoman Victoria Nuland told a briefing on Thursday.
"It's obviously not comfortable for us when they have a dispute between them, so our message to each of them is the same: Work this out, work it out peacefully, work it out through consultation."
Despite close economic ties, bitter memories of Japanese militarism run deep in China and South Korea. The territorial disputes show how the region has failed to resolve differences nearly seven decades after the end of World War Two.
The row with South Korea sparked a curious stand-off over a letter from Noda to Lee, which South Korea first declined to accept and then Japan refused to take back.
Narushige Michishita, security expert from Japan's National Graduate Institute for Policy Studies, said the intensity of the flare-up reflected domestic political pressures but also changing dynamics in the region.
"With rising China and more self-confident South Korea, the region is entering an era of turbulence," he said. "Amid a changing power balance between countries and a formation of new order, you will be left behind in a power game unless you are assertive."
Both Japan and South Korea face elections and China is preparing for a once-in-a-decade leadership change later this year. The last thing politicians want is to appear weak in dealing with neighbors over territory.
A South Korean newspaper said Noda was trying a "diplomatic gamble" to shore up his dismal ratings ahead of an election his Democrats look set to lose.
(Additional reporting by Tetsushi Kajimoto and Kiyoshi Takenaka in Tokyo; Chris Buckley in Beijing; Editing by Linda Sieg and Robert Birsel)