* Centrists make election gains, might be in new coalition
* Netanyahu likely to be hemmed in by domestic issues
* Pressure to moderate policy on Iran and Palestinians
By Crispian Balmer
JERUSALEM, Jan 23 (Reuters) - A weaker-than-expected showing by Prime Minister Benjamin Netanyahu in Israel's election might limit his room for manoeuvre against Iran and put his hardline stance toward Palestinian statehood under renewed pressure.
However, the focus of Israeli politics in the weeks ahead is likely to be on domestic issues, such as plugging the budget deficit, tackling complaints about military draft exemptions for religious students and finding cheaper housing for the young.
Exit polls have suggested that Netanyahu's right-wing Likud party, in alliance with the ultranationalist Yisrael Beitenu group, will win the most seats in the next parliament and so he should lead negotiations to build a governing coalition.
Although support for the rightist bloc undoubtedly slipped, early forecasts suggest he could still construct a narrow alliance, joining together ultra-Orthodox and nationalist religious parties not dissimilar to his outgoing cabinet.
But the emergence of a new centrist force, Yesh Atid (There is a Future) led by former television host Yair Lapid, will, many believe, compel him to seek a broader coalition. This will demand much more difficult negotiations that will touch on sensitive foreign and domestic policy options.
Netanyahu made only a vague reference to the Palestinian issue in his victory speech early on Wednesday, but immediately highlighted the issue of Iran's nuclear programme that many in the West believe is geared towards building an atomic bomb.
"The first challenge was and remains preventing Iran from obtaining nuclear weapons," he told party faithful in Tel Aviv.
Tehran has denied it is seeking nuclear weapons.
Although polls show most Israelis agree with Netanyahu that Iran threatens their country's existence, centrist and leftist parties, including Yesh Atid, made clear they thought it was the duty of international powers to resolve the problem.
"Concerning Iran, the U.S. should lead the military option, not Israel," Yaakov Peri, a former head of the Israeli internal intelligence agency and a Yesh Atid candidate, said this month.
TENSE U.S. TIES
Netanyahu has indicated he would be ready to launch a unilateral military strike, if needed, but analysts said Tuesday's vote did not give him a clear mandate to do so and instead reflected widespread unease a his approach to Tehran.
"The prime minister should understand that the people are telling him to be moderate on Iran," said Professor Gideon Ramat, with the Hebrew University.
"These elections have weakened Netanyahu."
Aaron David Miller, once a senior U.S. adviser on the peace process, said the apparent weakening of the right in Israel might help improve notoriously bad relations between Netanyahu and U.S. President Barack Obama.
Netanyahu's support for Jewish settlement building in the West Bank and his attempts to push the United States into adopting a tougher line toward Iran have caused regular friction between the two nations over the past four years and this week saw both leaders effectively launched on new terms in office.
"The fact is, if (Netanyahu) goes with Lapid and he reaches out to the centre, you're going to end up with an American-Israeli rapprochement to a certain degree," Miller told CNN.
The exit polls suggested Netanyahu's Likud-Beitenu ticket would win 31 of the 120 parliamentary seats, while Yesh Atid was projected to have come second with 18 or 19 seats.
Netanyahu immediately made overtures to Lapid, who struck a chord with ordinary voters with his call for affordable housing, spreading the economic burden and improving education. His party went out of its way to play down external issues facing Israel.
"A big majority of middle class Israelis have voted strongly against the priorities of the last government," said Dan Avnon, a political science professor at Hebrew University.
"These are the people who pay the taxes and serve in the army," he said. "I don't think they can be ignored."
On many issues, Lapid will find a sympathetic ear on the right, but two key issues could scupper any alliance - his demand that ultra-Orthodox religious students should do military service and his call to revive moribund Palestinian peace talks - however dim the prospects for progress appear.
The second point in particular will put him at loggerheads not just with many of Netanyahu's own supporters, but also another hardline party, Jewish Home, which in many ways is a natural fit with Likud-Beitenu and is set to take some 12 seats.
Jewish Home and its charismatic young millionaire leader Naftali Bennet reject any peace negotiations and instead want Israel to annex large chunks of the occupied West Bank - a proposal that has alarmed Washington and other Western allies.
"Netanyahu needs to work with Lapid and present a more moderate face to the world. If he doesn't, it is going to prove very problematic for him," said professor Shmuel Sandler at the Begin-Sadat Center at Bar-Ilan University.
"But it won't be easy to square the circle over the Palestinian issue," he added. "This won't be an easy road and it will be harder for (the prime minister) to hold the government together than it was before."
Coalition talks could take several weeks to complete and Netanyahu might in the end decide to stick with his current stable of political allies, preferring a slender majority to having to accommodate the demands of centrist newcomers.
But analysts said Israel's middle classes would frown on such an outcome and wanted to see the next government rise above party politics and factional infighting.
"Netanyahu has always proved he is a great survivor," said Avnon at Hebrew University. "Now he has to show he can also be a statesman." (Editing by Alastair Macdonald)