* Quarter of a million gather in Diyarbakir
* Three-decade conflict has scarred Turkey
* Ceasefire expected to mark Kurdish new year
* Cautious optimism in southeastern city (Rewrites with declaration of ceasefire)
By Ayla Jean Yackley
DIYARBAKIR, Turkey, March 21 (Reuters) - Jailed Kurdish rebel leader Abdullah Ocalan ordered his fighters on Thursday to cease fire and withdraw from Turkish soil as a step to ending a conflict that has killed 40,000 people, riven the country and battered its economy.
Hundreds of thousands of Kurds gathered in the regional centre of Diyarbakir cheered and waved banners bearing Ocalan's moustachioed image when a statement by the rebel leader, held since 1999 on a prison island in the Marmara Sea, was read out by a Kurdish politician.
"Let guns be silenced and poltics dominate," he said to a sea of red-yellow-green Kurdish flags. "The stage has been reached where our armed forces should withdraw beyone the borders...It's not the end. It's the start of a new era."
There was no immediate reaction from Prime Minister Tayyip Erdogan, who has taken considerable risks since elected in 2002, breaking taboos deeprooted in a conservative establishment, not least in the military, by extending cultural and language rights to Kurds. Two years ago, to the anger of hardliners, he countenanced secret talks with the PKK in Oslo.
The fighters would withdraw to their bases in the mountains of northern Iraq, which they have used as a springboard for attacks on Turkish soil. the Turkish air force has on a number of occasions attacked the strongholds.
Ocalan's Kurdistan Workers Party (PKK), regarded by the United States and the European Union as well as Turkey as a terrorist organisation, launched its campaign in 1984, demanding an independent Kurdish state in the southeast of Turkey. But in recent years it has moderated its demands to political autonomy and broader cultural rights in an area where the Kurdish language was long formally banned.
"There is a strategic shift happening," said Ertugrul Kurkcu, a parliamentarian from the pro-Kurdish BDP party. "The Kurdish liberation movement is moving from an armed campaign to a cultural one. And the PKK accepts this."
The scenes in Diyarbakir, broadcast live on television, would have been unthinkable even months ago. Throughout the conflict, insignia of the banned PKK has been strictly banned and any display would have resulted in arrest. A huge bonfire was lit as Kurdish "Newroz" new year celebrations began, a soundtrack of Ocalan's past speeches playing over loudspeakers.
"War happens, but at some point you have to dress your wounds. This is our chance now," said Bedri Alat, 73. "I remember peace. My grandson does not. He does not remember when Kurds and Turks lived as brothers. This is a last chance."
Ocalan appears to have retained authority over his fighters in Turkey and in the mountains of northern Iraq where they will now gather. But there are still dangers of division over the terms of any deal.
A settlement would lift a huge burden off Turkey, though it would be viewed with deep suspicion by hardline nationalists who fear Kurds would resume a drive for independence and undermine the Turkish state.
The war has drained state coffers, stunted development of the mainly Kurdish southeast and scarred the country's human rights record. A peace would bolster the NATO member's credibility as it seeks to extend influence across the Middle East, and remove a stumbling block from its path to join the EU.
Truces have been declared and secret talks held with the PKK in the past, but expectations this time have been fuelled by the openness with which the process has been conducted.
Leftist militants launched bomb and missile strikes on Turkish government and ruling party offices on Tuesday night in attacks which Prime Minister Tayyip Erdogan said were aimed at derailing the peace process.
Late on Wednesday, a small bomb exploded in front of a shop in an Istanbul suburb, damaging a vehicle and shattering windows, Dogan news agency reported. There was no immediate claim of responsibility.
"Peace won't come just because the prime minister says so. A ceasefire isn't enough to guarantee my rights and freedoms," said Mustafa Guner, 22, a literature student at Diyarbakir's Dicle University, sipping tea at a nearby cafe in a restored caravanserai.
"I am hopeful, but I am also wary and I am anxious."
HARD ROAD AHEAD
If a ceasefire holds, the path to disarmament and the reintegration of militants will still be long and vulnerable to sabotage. The fate of Ocalan, "Apo" to his allies, also remains uncertain, but any move to release him could be strongly opposed by critics who see any settlement as threatening Turkish unity.
The prospect of talks with the PKK would long have outraged many Turks who revile Ocalan and hold him personally responsible for the bloodshed.
An upsurge in violence last Summer and mass roundups of Kurdish activists appeared to lend momentum to the nascent peace process. Turkish intelligence officers began meeting Ocalan in October on his prison island in the Marmara Sea. In November, he proved his continued authority by ordering the end of a hunger strike by hundreds of jailed Kurds.
Growing Kurdish assertiveness in neighbouring northern Iraq's autonomous Kurdistan region and in war-torn Syria have only added to the sense of urgency.
"We are ready for both peace and war," a group of PKK youths in militant fatigues, their faces wrapped in headscarves, said from the stage, their statement a reminder of a widely-held view that the conflict could flare up again if this peace bid fails.
At the cafe in Diyarbakir, student Resan Erdogan, 25, a Kurd who shares the prime minister's surname, said a PKK withdrawal too early in the peace process would be disastrous for Kurds.
"The PKK is our insurance. Any rights we have gained are because they fought for them," he said as the sound of fighter jets from the city's air base thundered above, a reminder of the heavy military presence Turkey maintains in the region.
Abdullah Demirbas, a Diyarbakir district mayor, said there were likely to be more attempts to sabotage the process ahead.
"There are deep forces who want war and they are pervasive. They feed off blood," he told Reuters.
"The PKK, Ocalan and the government must be brave... There is massive social support for this process. There is hope, albeit restrained. That stems from disappointments in the past."
Ocalan, long reviled in the media as 'baby killer', was first sentenced to hang after his capture in Kenya, but the sentence was commuted to life imprisonment after Turkey abolished the death penalty in pursuit of European Union membership.
Demirbas said this was a last chance for peace.
"The next generation is like a storm. It is more radical. It has never known peace between Kurds and Turks. Now you can still convince many of them, we can still win them over. But if we lose them this time, they will never listen to us again."
(Editing by Ralph Boulton) (Writing by Daren Butler; Editing by Nick Tattersall and Peter Graff)