* 11 countries back financial transaction tax
* UK, Sweden, free-marketeers strongly opposed
* Greek police battle protesters as Merkel visits Athens
By John O'Donnell and Harry Papachristou
LUXEMBOURG/ATHENS, Oct 9 (Reuters) - Eleven euro zone countries agreed on Tuesday to press ahead with a disputed tax on financial transactions designed to help pay for the cost of fixing a crisis that has rocked the single currency area.
The initiative, pushed hard by Germany and France but strongly opposed by Britain, Sweden and other free-marketeers, gained critical mass at a European Union finance ministers' meeting in Luxembourg, when more than the required nine states agreed to use a treaty provision to launch the tax.
The so-called "Tobin tax", first proposed by Nobel-prize winning U.S. economist James Tobin in the 1972 as a way of reducing financial market volatility, has become a political symbol of a widespread desire to make banks, hedge funds and high-frequency traders pay a price for the crisis.
"This is a small step for 11 countries but a giant leap for Europe," Austria Deputy Finance Minister Andreas Schieder said. "The way is now clear for a just contribution from the banking and financial sector for financing the burdens of the crisis."
The agreement raised the prospect of a pioneer group of European states for the first time launching a joint tax without the unanimous backing of the 27-nation bloc, a move that may fragment the single market for financial services.
EU Tax Commissioner Algirdas Semeta told the meeting the number of states backing the initiative had passed the quorum for so-called "enhanced cooperation", provided some countries turn their oral backing into written commitment.
"I proposed this tax as a source of new revenue from an under-taxed sector, and a means of encouraging more responsible trading," Semeta said. "It would also prevent a patchwork of national bank taxes from creating difficulties for businesses in the Single Market."
However, critics say it could distort that market by giving banks and other traders incentives to shift their trading activities to European financial centres where the tax is not levied, or away from Europe altogether.
"People will arbitrage it. People will find a way around it," said David Stewart, CEO of London-based hedge fund firm Odey Asset Management, which runs around $6.5 billion.
"If someone really wants to buy a company that's good, I'm sure they'll keep on buying it. But if it's a synthetic derivative then they may go somewhere else ... More volume will go through London."
Britain, home to the region's biggest trading centre, will not join the scheme.
Austrian Finance Minister Maria Fekter said the 11 countries would present a model for how the tax would work by the end of the year, and it was realistic to expect the tax to be implemented by 2014.
Semeta said the countries aiming to launch the tax did not yet agree on where the proceeds should go or on what they should be spent.
"Some of them would like to spend it individually. Some of them prefer to use part of the proceeds to finance the EU budget. It is premature to say what will be the final outcome," he said.
The breakthrough was a surprise to many EU diplomats who had thought Germany might fail to convince sufficient countries to join the plan, which has been in the works for two years.
After heavy diplomatic pressure from Berlin overnight, Spain and Italy agreed to support the measure. Slovakia and Estonia said they would throw their weight behind it too.
The European Commission has said a tax on stocks, bonds and derivatives trades from 2014 could raise up to 57 billion euros a year if applied across all countries.
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The agreement was a victory for German Chancellor Angela Merkel on the day she travelled to Athens, epicentre of Europe's debt crisis, to express her support for near-bankrupt Greece staying in the euro zone.
Greek police fired teargas and stun grenades to hold back protesters who accuse Merkel of imposing devastating austerity on their country in exchange for two EU/IMF bailouts that have so far failed to turn the shattered economy around.
"A lot has been accomplished," Merkel said after talks with Prime Minister Antonis Samaras, adding that the tough path Greece is on will pay off if Greeks stay the course.
The financial tax deal masked a distinct lack of progress among finance ministers on other pressing issues facing the euro zone, including whether and when to provide a rescue package for Spain, and what to do about Greece's off-course programme.
The 17 euro zone ministers finally inaugurated their 500 billion euro permanent rescue fund on Monday, but danced around the question of how soon it might have to be used.
Ministers insisted Spain was taking the right actions to restore its public finances and did not need a bailout for now, even though many in the financial markets are convinced Madrid will need help within weeks rather than months.
The International Monetary Fund doused several euro zone countries' budget plans, including those of Spain and France, by revising down its 2013 growth forecasts for their economies.
Euro zone peers told Spanish Economy Minister Luis de Guindos that his country's budget cuts should take into account the weakness in the economy as regional policymakers debated whether to let Madrid slacken the pace of its austerity drive.
"The only thing I can say (about the IMF's forecasts for Spain) is to try to avoid that they happen," de Guindos said.
"Logically, we are working on the basis that such negative forecasts are not met," he said.
The ministers also had a "robust" discussion with the IMF about the long-term sustainability of Greece's debt mountain -- a key factor in whether international lenders release an urgently needed next tranche of aid to Athens.
An IMF director told a Dutch newspaper that European countries should consider restructuring the Greek debt they hold if the country's financial burden proves unsustainable.
Diplomats say euro zone governments would prefer to find ways to give Athens more time to meet its fiscal targets and postpone any consideration of official debt restructuring until after next September's German general election.
European Central Bank chief Mario Draghi told the European Parliament the euro zone economy faced a long, uphill road to recovery and the bloc was still suffering a crisis of confidence.
But he said there was no alternative to continued budget cuts.
(Additional reporting by Eva Kuehnen in Luxembourg, Noah Barkin in Berlin, Renee Maltezou and Andreas Rinke in Athens, Laurence Fletcher in London. Writing by Paul Taylor, editing by Mike Peacock)