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UPDATE 2-Italy inches closer to new government as parties haggle

Giselda Vagnoni and Angelo Amante

* 5-Star and PD expected to strike a govt deal

* Both sides will report to head of State later in the day

* Conte led the previous 5-Star/League coalition (Recasts, adds quotes, background)

ROME, Aug 28 (Reuters) - Tense talks aimed at forming a new Italian government inched forward on Wednesday as two major political parties, struggling to bury years of hostility and avoid snap elections, agreed to re-install Giuseppe Conte as prime minister.

The anti-establishment 5-Star Movement and the opposition centre-left Democratic Party (PD) entered formal coalition talks after a ruling alliance between 5-Star and the right-wing League party collapsed this month after prolonged infighting.

The talks, which remain tense and could still break down, had been at risk of collapse over who should be named prime minister but the PD confirmed on Wednesday that it had dropped its opposition to Conte, removing one big barrier to a deal.

The PD's leader also secured the backing of the party's executive on Wednesday to forge an alliance with 5-Star, despite a history of bitter relations between the two political rivals.

"We decided to agree to Conte as prime minister because that was what 5-Star wanted," PD boss Nicola Zingaretti said.

Both sides have yet to agree on other top government posts or reveal a common policy agenda, with only hours remaining before an effective Wednesday evening deadline for a deal.

President Sergio Mattarella has asked them to report back to him on progress later in the day. If they fail to strike a deal, he is expected to name a caretaker government and call elections as early as October.

"DEPUTY PM MUST BE FROM PD"

The focus of talks are now shifting to the role of deputy prime minister. The PD wants this job for one of its own, now that it has agreed to Conte staying on as prime minister.

"The problem is that if there is a premier from the 5-Star it is fair that his deputy is from the PD," PD deputy leader Andrea Orlando said on Twitter.

Conte, a virtually unknown lawyer when he was chosen by the League and 5-Star to lead their new government last year, is not a member of any political party, though he is seen as being close to 5-Star.

Even in the event of a deal, another potentially major roadblock remains. The 5-Star announced in a blog post on Tuesday that any deal would need to be approved by an online vote of its members.

Many of its rank and file are hostile to the PD and have used social media to urge Di Maio not to do a deal.

"Every party has its procedures. We hope it is going to be a great day," PD's Senate Andrea Marcucci told reporters before entering a meeting with his 5-Star counterpart in parliament.

The prospect of a new government led by Conte has buoyed markets, betting that Italy will avoid snap elections. Investors fear they would be won by Matteo Salvini's hard-right League party, which would put Rome on a collision course with the European Union over expansionary government spending.

In mid morning trade the gap between Italy's 10-year bond yield and Germany's bund was at 182 bps, the lowest since May 2018, down from Friday's 200 bps.

Conte's likely appointment as prime minister of Italy's 67th government since World War II was also hailed on Tuesday by U.S. President Donald Trump.

(Additional reporting by Valentina Consiglio, Gavin Jones; Editing by Jon Boyle)