UPDATE 1-Bitter setback for Merkel months before German election
* SPD and Greens win key regional election by single seat
* Defeat a blow to Merkel as she gears up for federal vote
* Left now holds blocking majority in upper house
* Lower Saxony fails to silence critics of FDP, SPD leadership
BERLIN, Jan 21 (Reuters) - In an extremely tight German state election that seemed to produce few clearcut winners, there was no argument over who the biggest loser was - Chancellor Angela Merkel.
Her Christian Democrats (CDU), led in Lower Saxony by rising star David McAllister, had convinced themselves over the past week that they were on the verge of a stunning come-from-behind victory in the northwestern state, a major agricultural and industrial region that is Germany's closest approximation to a U.S.-style swing state.
But on Sunday, they came up agonisingly short, losing power to the centre-left Social Democrats (SPD) and Greens, who together managed to win one more seat in the state assembly than the centre-right.
It is a bitter defeat for the 58-year-old chancellor, even if she remains a strong favourite to win a third term in a federal election eight months from now.
"It is a setback. I won't pretend it isn't, and it hurts all the more because it was so close," Hermann Groehe, a close Merkel ally and general secretary of the CDU, told German radio.
In one fell swoop, the result gives the centre-left a majority in the Bundesrat upper house of parliament, meaning the opposition can block major legislation from Merkel's government and initiate laws themselves.
That will not change after the national election in September, even if Merkel's centre-right coalition with the liberal Free Democrats (FDP) manages to hold onto power.
In the run-up to the federal vote, Merkel's room for manoeuvre will be limited, and the notoriously risk-averse German leader may take a more cautious stance on a range of policy issues, including her management of the euro zone debt crisis.
"I assume it won't be possible to push anything through the Bundesrat that the SPD doesn't want," said Volker Kauder, leader of the CDU in parliament.
The vote is also a blow to McAllister, the 42-year-old half-Scot who had ruled Lower Saxony since 2010 and become a protege of the chancellor, declaring on the eve of the vote that he was happy to be "Merkel's Mac".
There will be much hand-wringing in the CDU about McAllister's not-so-subtle hints to supporters in the weeks before the election that they use their votes to boost the score of the FDP.
His message clearly resonated with CDU voters, but perhaps stronger than he would have liked.
The FDP, which had been expected to struggle to make the 5 percent threshold needed to enter the state assembly, ended up with a surprisingly strong 9.9 percent, largely thanks to CDU backers who split their two votes. In German elections voters cast ballots for both a party and a local candidate.
Yet the FDP's gains appear to have come at the expense of the CDU, which scored 36 percent, down 6.5 points from their last result in Lower Saxony in 2008 and well below the 40 percent-plus that opinion polls had forecast.
"The CDU has now seen very clearly how bad things can go when you campaign for a split vote, as it did for the benefit of the FDP," said Oskar Niedermayer, a political scientist at Berlin's Free University.
Merkel's CDU has now suffered defeats to the SPD and Greens in five states over the past two years, including in their longtime southern stronghold of Baden-Wuerttemberg and in Germany's most populous state, North Rhine-Westphalia.
Of Germany's 16 federal states, only three are now ruled by centre-right coalitions like her federal partnership in Berlin.
The string of losses is likely to fuel anxiety about Merkel's ability to leverage her own popularity into votes for her party.
The FDP were hailed as the big winners of Sunday's vote, but the result failed to silence internal critics who want to jettison national party leader Philipp Roesler before the federal vote.
Leading Roesler critic Dirk Niebel, who serves as German development minister, said the Lower Saxony surprise could not mask the FDP's problems at the national level and demanded a special congress to debate the party's future.
At a closed-door meeting of the FDP leadership on Monday in Berlin, Roesler offered to step aside and cede the chairmanship to parliamentary leader Rainer Bruederle, one party source told Reuters. There was no sign his colleagues had accepted the resignation offer.
The SPD will take some satisfaction after seeing their colourless candidate, Hanover Mayor Stefan Weil, oust the popular Merkel ally McAllister, but the narrow victory does not give them the major momentum-boost they had been hoping for.
Instead it highlighted the problems of their own chancellor candidate Peer Steinbrueck, who on Sunday accepted responsibility for weakening the party's score in Lower Saxony with a series of gaffes.
As with Roesler, the result is unlikely to quiet voices within the SPD who question Steinbrueck's suitability as a challenger to Merkel.
The only party that came out an undisputed winner from Lower Saxony was the Greens, who with 13.7 percent of the vote scored their best ever result in the state. But without a stronger performance from the SPD, their natural allies, the environmentalist party has little hope of dislodging Merkel, as they did her loyal ally McAllister.
"We are doing our part," said Greens leader Cem Oezdemir. "But the SPD needs to look closely at how they can improve their own score."