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UPDATE 2-Investors pile into Italian debt in final auction of 2017

* Over 9 bln euros of demand for 5 and 10yr Italian debt

* Italian parliament expected to be dissolved before end of week

* Most euro zone yields up 2-3 bps on the day

* Euro zone periphery govt bond yields http://tmsnrt.rs/2ii2Bqr (Updates to reflect shift in yields)

LONDON, Dec 28 (Reuters) - Investors hoovered up Italy's government bonds at an auction on Thursday as demand for the country's debt picked up again at higher yields after a recent sell-off prompted by concerns over an upcoming election.

On a day when most euro zone government yields rose, the Italian debt agency sold 4.9 billion euros of five and 10-year bonds, or BTPs, generating over 9 billion euros of demand in the process.

"I think the auction went quite well, especially for the current holiday period," said DZ Bank analyst Sebastian Fellechner.

"I think yesterday we saw some spread-widening that has made Italian bonds more attractive, that is why maybe investors are taking advantage," he said.

Italy's 10-year borrowing costs actually dropped around the time of the auction, but were set to end the day 4 basis points higher at 1.95 percent on the back of some political headlines.

Italian Prime Minister Paolo Gentiloni met President Sergio Mattarella on Thursday in the first formal step ahead of the dissolution of parliament which is necessary before an election can be called, a government source told Reuters.

However, the move in Italian yields was not out of step with the rest of the market. Most euro zone bond yields were 4-5 bps higher on the day, and going into a new year when the European Central Bank is set to halve its bond purchase programme.

The gap between Italian and German 10-year borrowing costs narrowed 2.5 basis points to just below 151 bps at one stage.

The yield on Germany's 10-year government bond, the benchmark for the region, was up 5 bps to 0.43 percent, only a shade below a five-week high hit last week.

Italian government bond yields have risen in the last couple of weeks after reports emerged that a parliamentary election was set to take place in March.

Some investors sold Italian government bonds - which have been a stellar performer overall this year - on concerns that the anti-establishment 5-Star Movement is performing strongly in the polls.

(Reporting by Fanny Potkin and Abhinav Ramnarayan; Editing by Gareth Jones)