(Adds Japanese reaction to exemption)
By Arshad Mohammed and Andrew Quinn
WASHINGTON, March 20 (Reuters) - The United States on Tuesday exempted Japan and 10 EU nations from financial sanctions because they have significantly cut purchases of Iranian crude oil, but left Iran's top customers China and India exposed to the possibility of such steps.
The decision is a victory for the 11 countries, whose banks have been given a six-month reprieve from the threat of being cut off from the U.S. financial system under new sanctions designed to pressure Iran over its nuclear program.
The list did not, however, include China and India, Iran's top two crude oil importers, nor U.S. allies South Korea and Turkey, which are among the top-10 consumers of Iranian oil.
Japanese Finance Minister Jun Azumi welcomed the decision and said Japan would continue to cut its imports of Iranian oil at a set rate in the future.
"The decision takes account of Japan's steps on Iranian oil, including its future response," he told reporters at a regular briefing.
A U.S. official held up Japan's estimated 15-22 percent cut in oil purchases from Iran in the second half of last year as an example for other nations, saying it did so after the "tragedy" of the earthquake that caused the Fukushima nuclear disaster.
"Japan was a model," State Department Special Envoy and Coordinator for International Energy Affairs Carlos Pascual told lawmakers. "If Japan was able to do what it did ... that should be an example to others that they could potentially do more."
Pascual declined to set a benchmark for countries to secure a 180-day exemption from the U.S. financial sanctions, noting U.S. law only says they must "significantly reduce" oil imports from Iran and must continue to do so to win future exemptions.
The 10 nations from the European Union, which has already decided to stop importing Iranian oil from July, were Belgium, Britain, the Czech Republic, France, Germany, Greece, Italy, the Netherlands, Poland and Spain, the State Department said.
"The actions taken by these countries were not easy," U.S. Secretary of State Hillary Clinton said in a statement. "We commend these countries for their actions and urge other nations that import oil from Iran to follow their example."
While China and India and others remain exposed to the possibility financial sanctions if they do not significantly cut Iranian imports, U.S. law gives President Barack Obama the ability to waive such steps if this is in the national interest.
The United States has gradually tightened sanctions due to Iran's failure to answer questions about its nuclear program, which Washington and its allies suspect is a cover to develop nuclear weapons. Iran says it is solely to generate power.
World oil prices have surged in recent weeks on concerns about tensions with Iran - including the possibility of Israel attacking Iranian nuclear facilities - and on worries sanctions would reduce supplies to an already tight global market.
Crude prices have risen to more than $125 barrel on the supply squeeze but on Tuesday dropped nearly $1.50 to $124.25 in London after Saudi Arabia assured markets that it was ready to increase exports to meet any shortfall from Iran.
Mark Dubowitz, an advocate for tougher sanctions on Iran and the head of the Foundation for Defence of Democracies, said Japan's example was likely to be significant.
"The key number will be what Japan agreed to," he said. "This will be the number that other countries will have to meet or otherwise make the case to the administration why their energy circumstances demand a lower reduction."
Ray Takeyh, an Iran expert at the Council on Foreign Relations think tank, said the exemptions for Japan and the European Union were predictable because they had done the most to cut their imports of Iranian crude.
"Japan has taken action in looking for alternative suppliers, while India and China have not demonstrated that they are in compliance with the sanctions," Takeyh said.
All 27 EU nations have agreed to an embargo on Iranian crude purchases by banning new purchases from Jan. 23 and phasing out existing contracts by July 1.
A U.S. official, who spoke on condition of anonymity, said exemptions were only granted to 10 of the 27 because the others "did not import Iranian crude in 2011."
Under the 2012 National Defense Authorization Act, Obama has the ability to impose financial sanctions on foreign banks that carry out financial transactions with Iran's central bank "for the purchase of petroleum or petroleum products from Iran" if several conditions are met.
The penalties include effectively cutting off a foreign bank from the U.S. financial system, a risk few are likely to take.
However, the law gives Obama an explicit exemption under which he can choose not to apply sanctions if he determines that the country with primary jurisdiction over the bank has "significantly reduced" its volume of crude oil purchases.
The exemptions apply for 180 days and can be renewed every six months thereafter.
Under U.S. law, the sanctions cannot be imposed before June 28, giving countries time to adjust.
Senator Robert Menendez, a New Jersey Democrat who was one of the major sponsors of the sanctions legislation, welcomed Clinton's decisions and praised the EU and Japan "for their forthright and expedient action."
"The sanctions are working," he said. "Our message to Iran is clear - we are serious about this sanctions regime. It is up to the Iranians to determine what they value more, their nuclear program or the political and economic stability of their state." (Additional reporting by Susan Cornwell, Tim Gardner and Emily Stephenson, and by Rie Ishiguro in Tokyo; Editing by David Brunnstrom and Paul Simao and Michael Perry)