* Stockpile of 20 percent uranium rises sharply since September
* But still below Israeli "red line" for Iran nuclear programme
* Iran stopped converting nuclear material into reactor fuel
* Reason unclear, but may be linked to manufacturing process
By Fredrik Dahl
VIENNA, Nov 27 (Reuters) - An increase in Iran's higher-grade uranium stockpile is worrying but may arise from a bottleneck in making reactor fuel rather than a bid to quickly accumulate material that could be used for nuclear weapons, diplomats and experts say.
The issue of when and how fast Iran might be able to build an atomic bomb if it chose to do so is closely watched in the West because it could determine any decision by Israel to launch pre-emptive strikes against the Islamic Republic.
Tehran's move this year to use a big part of its most sensitive material - which could otherwise be turned into bomb-grade uranium - for civilian fuel purposes helped ease intense speculation of an imminent attack by the Jewish state.
But tension may soon flare again if Iran's holding were to rapidly approach an amount that would be enough for a weapon, either by stepping up output of higher-enriched uranium or by no longer using the material to produce reactor fuel, or both.
"The question is, at what point do they cross the critical point ... when we enter the danger zone?" one senior diplomatic source said. "Will they decide to voluntarily decide to stay clear of that point?"
A U.N. nuclear watchdog report issued this month showed that Iran in late September suddenly stopped converting uranium gas enriched to a fissile concentration of 20 percent into oxide powder to make fuel for a medical research reactor in Tehran.
Because Iran's enrichment work at the same time continued unabated, the halt meant that its stockpile of the higher-grade uranium rose by nearly 50 percent to 135 kg in November compared with the level in the previous quarterly report in August.
"It is very puzzling," said one intelligence official from a country which suspects Iran is seeking to develop a nuclear weapons capability, a charge Tehran denies, about the finding reported by the U.N. International Atomic Energy Agency (IAEA).
It could be because of a technical malfunction or a "test balloon" to see how the West would react, the official added.
It took Iran a significant step closer to the amount of roughly 250 kg seen as sufficient for one atomic bomb if refined further, which Israel has signalled is a "red line" for Iran's nuclear programme that may be reached by mid-2013.
"By the late spring, at this pace, Iran will have more than enough to arm its first weapon," said Emanuele Ottolenghi of the Foundation for the Defense of Democracies, a think-tank which has advised the U.S. government on sanctions against Iran.
But some Western diplomats and analysts believe Iran may have let its stockpile grow for reasons related to the fuel manufacturing process, and that it could at some point re-start conversion of uranium gas.
"I think it is a technical issue," one envoy said.
Producing reactor fuel involves several steps. First, the enriched uranium must be converted into oxide powder, then it is turned into fuel plates, and this could help explain the halt in feeding more of the gas into production process.
"It is probably because it is easier and quicker to make the conversion to oxide than to produce the fuel elements," Mark Fitzpatrick, a nuclear proliferation expert at the International Institute for Strategic Studies think-tank, said.
Fitzpatrick said he believed it was "more of a bottleneck" issue, adding: "It is alarming because it brings the 20 percent stockpile closer to a weapons amount. But it is not alarming in the sense that this was a strategic decision on Iran's part."
Former chief U.N. nuclear inspector Olli Heinonen said he did not find the Iranian nuclear fuel development unusual.
"This is not an industrial manufacturing process, but rather a pilot scale operation," Heinonen, now at Harvard University, said about the production of 20 percent reactor fuel in a facility near the city of Isfahan, which started in late 2011.
"To turn all the material in Isfahan to fuel plates will take more than year. Before doing so, they also want to see the performance of the plates," Heinonen said.
Even so, Western diplomats and others said, Iran's growing accumulation of 20 percent refined uranium in combination with a major expansion of its enrichment capacity in an underground facility are increasing concern over Tehran's intentions.
It may also further complicate diplomatic efforts to resolve the decade-old dispute peacefully as major powers demand that Iran stop all 20 percent enrichment, shut down the Fordow underground site and ship out the stockpile of the material.
"By converting (20 percent uranium) into something else, it reduces the tension, but in no way does it resolve the issue as a whole. They continue to enrich," the diplomatic source said.
Iran says it wants a recognition of what it sees as its right to refine uranium for peaceful energy purposes and a lifting of sanctions, demands rejected by Western powers.
The United States and its allies are especially watching how much 20 percent uranium Iran is amassing, as this is a short technical step away from the 90 percent level needed for bombs.
Iran has sharply expanded this activity - which compares to the 3.5 percent level needed for most nuclear power plants - over the last year to about 15 kg per month.
By August, Iran had produced 233 kg since the work started in early 2010. About 40 percent has been fed into conversion for making fuel, or was about to be, a step that at least for the time being removed it from any dash for a bomb.
Western diplomats are now waiting to see when Iran will switch on about 700 newly-installed centrifuges at Fordow, which would allow it to sharply expand 20 percent enrichment and once again raise the stakes in its stand-off with its foes.
"I think Iran has been trying to calibrate its advances, not necessarily to lower tension, but to try to manage the crisis," Fitzpatrick said. (Additional reporting by John Irish; Editing by Mark Heinrich)