* Rebels launched assault on Tuesday morning
* First attack on major town since ceasefire deal
* Upper Nile is country's main oil producing state
By Carl Odera
JUBA, Feb 18 (Reuters) - South Sudanese rebels said they had seized control of the capital of oil-producing Upper Nile state on Tuesday, in an assault the government branded a flagrant breach of a ceasefire signed in January.
The rebel strike was the first attack on a major town since the Jan. 23 ceasefire deal, but the government denied rebels now controlled Malakal, which lies on the fringes of a key oil-producing area in the country's northeastern corner.
The clashes will fuel concerns over the security of South Sudan's northern oil fields - an economic lifeline for the world's newest state - and raise pressure on both camps to revive stalled peace talks in neighbouring Ethiopia.
Gathoth Gatkuoth, commander for rebel forces in Upper Nile who is a close ally of former vice president Riek Machar, told Reuters by telephone his forces struck Malakal on Tuesday morning and swiftly retook the dusty market town.
Both camps have repeatedly accused the other of breaking the ceasefire accord. South Sudan on Tuesday voiced frustration at the lack of progress made deploying regional observers to flashpoint areas and said fighting continued in Malakal.
"It is a flagrant violation of the cessation of hostilities agreement signed by both sides," South Sudan's Information Minister Michael Makuei told Reuters. "We have been calling on the envoys to expedite the establishment of the monitoring mechanism but nothing has happened so far."
Malakal lies about 140 km (90 miles) from Paloch, an oil complex where a key crude oil processing facility is situated.
South Sudan says it has already been forced to cut oil production by a fifth to 200,000 barrels per day, all of which is pumped from Upper Nile. Rebel control of Malakal could raise concerns over its ability to maintain the rate of output.
"All the oil from the fields around Upper Nile is pumped to Paloch," said Jacob Jok Dut, director of the Centre for Democracy and International Analysis who follows the oil industry closely. "If Malakal comes under rebel control, then definitely there will be tension in and around Upper Nile."
Oil accounts for 98 percent of government revenues. Oil firms in South Sudan, a country the size of France, include China National Petroleum Corp, India's ONGC Videsh and Malaysia's Petronas. Work in some fields has been suspended.
Thousands of people have been killed and more than 800,000 have fled their homes since fighting began two months ago, triggered by a power struggle between President Kiir and Machar, his former deputy whom he sacked in July.
Situated on 650 km (400 miles) north of the capital Juba on the banks of the White Nile, Malakal first fell to rebels after fighting broke out in mid-December before government forces recaptured it last month.
The rebel move on Malakal may be aimed at strengthening its hand before a second round of peace talks in Ethiopia.
An army spokesman in Juba said communication has been lost with the town and fighting continued in Malakal's southern area.
U.N. spokesman in South Sudan, Joe Contreras, said a U.N. camp in Malakal, where many of the displaced people had fled for protection, had been caught in the crossfire.
Peace talks had been due to resume last week, but were held up by a rebel demand that four remaining political prisoners held by the government be released and the Ugandan military, which is supporting Kiir's army, withdraw from South Sudan.
Government officials privately acknowledge negotiations are unlikely to make progress until the senior political figures are freed. The government says the detainees tried to launch a coup.