* Mubarak release could exacerbate political crisis
* Army-backed government and Muslim Brotherhood in standoff
* Mubarak will be held under house arrest after release
By Michael Georgy and Shadia Nasralla
CAIRO, Aug 22 (Reuters) - Deposed Egyptian leader Hosni Mubarak could leave prison on Thursday after a court ruling that further divided a country in turmoil since the army toppled Islamist President Mohamed Mursi seven weeks ago.
Convening at the Cairo jail where Mubarak is held, the court ordered the release of the military man who ruled Egypt for 30 years with an iron fist until he was overthrown during the uprisings that swept the Arab world in early 2011.
The prime minister's office said he would then be placed under house arrest, which could be an attempt to placate the many who will object to the release of the man they held mass protests to eject in 2011.
Citing a security source, the state news agency said Mubarak would "likely" be transported to one of the state's vital installations or one of two military hospitals where he will be guarded under heavy security.
Mubarak, 85, was sentenced to life in prison last year for failing to prevent the killing of demonstrators. But a court accepted his appeal earlier this year and ordered a retrial.
The ailing former air force pilot probably has no political future, but the court ruling made some Egyptians uncomfortable.
"His regime was foul. He damaged the country a lot. Unemployment high, no services, no health, no education. This is not a good day for the country," said Hassan Mohamed, 66, an engineer.
Refilling juice cartons in a convenience store, Amr Fathi also expressed disappointment. "I'm not happy, of course. He oppressed us a lot back in the day," he said.
Political upheaval triggered by the army overthrow of Mursi has kept many Egyptians anxious for months.
The military announced a road map designed to bring democracy back to Egypt. But that has not created a sense of stability in the Arab world's biggest nation.
At least 900 people, including 100 soldiers and police, have been killed in a crackdown on Mursi supporters in the past week, making it the country's bloodiest internal episode in decades.
The clampdown, which has included the arrests of top leaders of Mursi's Muslim Brotherhood, appears to have weakened the Arab world's oldest and arguably most influential Islamist group.
It has been struggling to get people onto the streets to protest what it calls a military coup since security crushed pro-Mursi protest camps in Cairo.
Brotherhood supporters called on Egyptians to hold "Friday of Martyrs" marches against the military takeover.
A grouping calling itself The National Coalition to Support Legitimacy, which has been demanding Mursi's reinstatement, said in a statement, "We will remain steadfast on the road to defeating the military coup."
Mubarak's release from jail would reinforce the Brotherhood's view that the armed forces, led by General Abdel Fattah al-Sisi, is trying to rehabilitate the old government.
'HE WAS A GREAT MAN'
Mubarak is still being retried on charges of complicity in the killing of protesters during the revolt against him, but he has already served the maximum pretrial detention in that case.
The court ruling removed the last legal ground for his imprisonment in connection with a corruption case, following a similar decision in another corruption case on Monday. Mubarak will not be allowed to leave Egypt and his assets remain frozen.
Some Egyptians were happy to hear Mubarak could soon leave Cairo's Tora prison, where many of his enemies were jailed during his ruthless crackdowns on Islamists.
"He was a great man; he shouldn't be in prison. He is an old man," said Ibtisaam, 19. "Under Mubarak, we lived in safety. Now anyone can come up to us, thugs and all."
Egypt has witnessed a deterioration in law and order since Mubarak was toppled. Political violence that erupted after Mursi's ouster has also made Egyptians uneasy.
It is likely to drag on, with the authorities vowing to wipe out "terrorism", and the Muslim Brotherhood refusing to give up the fight to bring Mursi back to power.
The United States and the European Union are both reviewing aid to Cairo in light of the bloodshed, but Saudi Arabia, a foe of the Brotherhood, has promised to make up any shortfall.
The European Union stopped short of agreeing immediate cuts in financial or military assistance to Cairo on Wednesday, as the bloc's foreign ministers held emergency talks to find ways to help bring an end to violence in Egypt.
The decision acknowledges Europe's limited economic muscle in forcing Egypt's army-backed rulers and the Muslim Brotherhood supporters of Mursi into a peaceful compromise.
It also reflects a concern that abruptly cutting aid could shut off dialogue with Cairo's military rulers and damage Europe's ability to mediate in any future negotiations to end the worst internal strife in Egypt's modern history.
Egypt has said repeatedly it does not want foreign powers to interfere in the standoff with the Brotherhood.
"Egypt can never accept an interference in its sovereignty or the independence of its decisions or an interference in its internal affairs," said Egyptian Foreign Minister Nabil Fahmy in a statement after the EU talks.
"The only standard that rules Egypt's decisions is the supreme interest of the country and its national security." (Reporting by Michael Georgy; Editing by Will Waterman and Peter Cooney)