By Michael Georgy
NAJAF, Iraq (Reuters) - U.S. warplanes have pounded areas near a holy shrine where radical Shi'ite militia are holed up after their leader, Moqtada al-Sadr, defied a final demand from Iraq's interim prime minister to disarm.
Suspected U.S. AC-130 gunships struck on Thursday repeatedly against positions held by Sadr's militiamen, sheltering in and around the Imam Ali mosque in Najaf, the holiest Shi'ite shrine.
Orange flashes and white sparks lit the night sky above Najaf, but it was not immediately clear if the explosions marked the start of a threatened assault.
A large cloud of smoke rose from the ancient cemetery where Sadr's Mehdi militiamen have fought U.S. troops for two weeks. Armoured vehicles appeared to head to the battle zone around the shrine and the cemetery, where heavy machinegun fire was heard.
"This is the final call for them to disarm, vacate the holy shrine, engage in political work and consider the interests of the homeland," interim Prime Minister Iyad Allawi t old a Baghdad news conference.
In a letter allegedly from Sadr, the cleric urged his militia to hand over the Imam Ali shrine to the city's religious authority but rejected demands that he disband the Mehdi Army and join the country's political process.
But the letter carried a seal that is not consistent with marks of previous letters from Sadr and fighting raged on.
Earlier inside Najaf, in the warren of dusty streets littered with spent shells, the mood was one of defiance.
One man walked down the street near the shrine with two grenades in his hand, cursing Allawi and his U.S.-backed troops.
"They are a joke. Let them come here. We are waiting for the fight and we all want to be martyrs anyway so we have nothing to lose," said the Mehdi Army fighter, Ibrahim.
CONCILIATION AND DEFIANCE
Away from the shrine area, three mortar bombs hit a Najaf police station, killing seven police and wounding 21 others, officers said. Police said Mehdi militiamen fired the salvo.
Sadr loyalists had threatene d to attack oil infrastructure in southern Iraq if U.S.-led forces continued assaults in Najaf and witnesses said on Thursday saboteurs had set alight the headquarters of the South Oil Co. in the port city of Basra.
"It was not an accident. The fire is huge," said an official of the state-owned company.
In Baghdad, a mortar bomb hit the roof of the U.S. embassy in the heavily fortified Green Zone, slightly wounding two American employees, an embassy spokesman said.
Sadr reverted to his trademark defiance after two days in which he appeared to be willing to disarm his militia and end his two-week-old stand in Iraq's holiest Shi'ite shrine.
Asked about government demands, Sheikh Ahmed al-Sheibani, a senior Sadr aide and Mehdi Army commander, told reporters earlier in Najaf: "It is very clear that we reject them."
The rebellion has badly dented Allawi's authority, killed hundreds and rattled world oil markets. Oil prices hit a new record of $48.75 for a barrel of U.S. light crude.
Allawi said while h e welcomed the sometimes conciliatory comments by Sadr and his aides, he wanted something concrete in writing. He refused to be drawn on whether Sadr had been given a deadline, although his senior officials said it was hours.
Any storming of the mosque could provoke outrage among Iraq's majority Shi'ite community, especially if any of the 2,000 U.S. marines encircling Najaf are involved.
White House spokesman Scott McClellan said Sadr had to meet Baghdad's demands. "The Iraqi government has made it very clear that he cannot have a separate law for himself," he said.
In Baghdad, U.S. troops, tanks and armoured vehicles overran the cleric's stronghold in the Shi'ite slum of Sadr City meeting little resistance, witnesses said. The troops later withdrew to the outskirts of the area, home to about two million people.
The U.S. military said at least seven Iraqi gunmen were killed in Sadr city on Thursday.
Most Najaf residents too were sceptical fighting would end.
"What peace? I don't bel ieve it. Look at this hell," said Talib Moussa, a 35-year-old labourer.
Sadr has more than once vowed to fight to the death in Najaf and has proved a wily strategist in past confrontations.
Despite the plump, bearded cleric's youth -- he is about 30 -- the latest rebellion has transformed him into the most recognisable face of resistance to the U.S. presence in Iraq.
One U.S. marine was killed in action in Najaf on Wednesday, the U.S. military said. More than 700 U.S. troops have been killed in action since the start of last year's U.S.-led invasion.