* Sanaa prepares for rival protests after talks collapse
* Official says Houthis retract decision to join new government
* Houthis say no talks before government restores fuel subsidies
By Mohammed Ghobari
SANAA, Aug 24 (Reuters) - Talks on forming a new Yemeni government collapsed on Sunday over demands by Shi'ite Muslim Houthis to restore fuel subsidies cut by President Abd-Rabbu Mansour Hadi, officials said, and further demonstrations in the capital Sanaa were expected.
The Houthis, who have been fighting for years for more power for their Zaydi Shi'ite Muslim sect in north Yemen, have massed tens of thousands of supporters on the outskirts of Sanaa to press the government to quit and to restore fuel subsidies.
The government offered on Saturday to resign within a month to pave the way for a technocrat administration that would review the fuel subsidy issue, but officials said the Houthis had demanded an immediate reinstatement of the subsidies.
The standoff has raised fears for the stability of Yemen, a majority Sunni Muslim country of 25 million that is allied with the United States and borders major oil exporter Saudi Arabia.
The government blamed the Houthis for the failure of talks.
"The Houthis have reneged on all previous understandings, including joining a new government and an offer to reduce the price of oil products, at the first government meeting," Abdel Malek al-Mekhlafi, a spokesman for the government committee assigned to negotiate with the Houthis, told Reuters.
"They have threatened to escalate (their protests) if the decision to raise fuel prices is not cancelled," he added.
Daifallah al-Shami, a leader of the Houthi group, made clear the demand for reinstating fuel subsidies was non-negotiable for his side and said the peaceful protests would continue.
"(Reversing the increase in fuel prices) is a popular demand and cannot be abandoned," Shami told Reuters. "No other issues can be discussed."
MORE RALLIES PLANNED
Rival demonstrations are scheduled to take place in Sanaa later on Sunday, one by Houthi loyalists and one by supporters of President Hadi, but residents said they did not expect the two to come into contact with each other.
Hadi has put the army on a state of heightened alert to tackle any resort to violence during the Sanaa demonstrations.
The Houthis have been emboldened by recent military gains against rival Sunni Muslim tribesmen and allied government troops north of the capital.
In a report on their website on Sunday, the Houthis said that one of their members had been killed and three wounded in an attack by Sunni Islamist gunmen on one of their offices in eastern Sanaa on Saturday.
The al-Qaeda-affiliated Ansar al-Sharia said in messages posted on social media that two of its members had been killed in the incident.
Yemen's Gulf neighbours and Western partners, which helped the country stave off civil war in 2011, have watched the dispute between Sanaa and the Houthis with mounting concern.
Last week, they urged the Houthis to stop trying to gain territory by force and to engage in a political transition process.
The government's decision last month to raise fuel prices was part of efforts to rein in its budget deficit and helped the impoverished Arab state to conclude talks on a $560 million loan from the International Monetary Fund (IMF)..
Last year, it spent about $3 billion on the fuel subsidies, nearly a third of all state revenues.
The Houthis, whose protests began last Monday, have pitched tents on a road leading to the airport near to key ministries. Their protests have tapped into wider public anger among Yemenis over the subsidy cuts.
A previous attempt to cut subsidies, in 2005, led to unrest in which about 20 people were killed and more than 200 wounded. The reform was cancelled. (Reporting by Mohamed Ghobari; Writing by Sami Aboudi; Editing by Gareth Jones)