UPDATE 1-Key ally pulls out of India government over reforms

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By Sujoy Dhar

KOLKATA, India, Sept 18 (Reuters) - The biggest ally in Prime Minister Manmohan Singh's government pulled out of the ruling coalition on Tuesday, escalating a political firestorm over big-ticket reform measures launched last week to revive India's flagging economy.

Mamata Banerjee, the chief minister of West Bengal state, had demanded the government reverse its decision to raise diesel prices and open India's supermarket sector to investment from foreign chains such as Wal-Mart Stores.

Her withdrawal and that of her 19 MPs in the lower house of parliament is unlikely to destabilise the government in the short term as Singh's Congress party can count on other parties for support.

But it might embolden Banerjee and other parties to intensify ongoing protests against unpopular economic policies that the government sees as crucial to reining in a bloated fiscal deficit and improving investor sentiment.

"The government has lost their credentials. If they cannot keep their friendship with us, they cannot keep it with anyone," Banerjee told reporters after a meeting of her Trinamool Congress party (TMC) in the eastern city of Kolkata, where her state government is based.

Banerjee has also withdrawn half a dozen ministers in the government, the most high profile being the railways ministry portfolio. They will submit their resignations on Friday, she said.

BACKLASH

A popular backlash against retail liberalisation forced the government into an embarrassing climbdown on the reform last year. Singh revived the measure on Friday, although opponents of the policy have vowed to reverse it once again.

But Singh's Congress party appears confident of surviving the opposition against the reforms and has held firm against calls for the measures to be rolled back.

Several party and government officials have told Reuters that Congress leader Sonia Gandhi had assessed the risks of losing coalition allies over the measures and concluded th e go vernment wa s safe.

Banerjee came to power in West Bengal in 2011, ending more than three decades of Communist rule in the state. Colloquially known as "Didi", or "elder sister", Banerjee's supporters hail her as a champion of India's poor and dispossessed.

But her politics are a thorn in the side of the government. Her protests had been instrumental in blocking a slew of economic measures, from retail reform to allowing foreign direct investment into India's aviation and insurance sectors.

"We waited enough time," Banerjee said. "They have to withdraw FDI in retail if they want us to stay, they have reverse their decisions on LPG subsidy and diesel hike." (Writing by Matthias Williams; additional reporting by Arup Roychoudhury and Annie Banerji; editing by Ross Colvin)