(Updates prices, adds comment)
By Marius Zaharia, Sudip Kar-Gupta and John Geddie
LONDON, Feb 5 (Reuters) - Greek markets recovered from a sharp sell-off on Thursday after the European Central Bank agreed to a local lifeline for Greek banks, having earlier said it would stop accepting Greece's bonds in return for funding them.
The ECB's abrupt announcement that it will stop funding the country's banks from Feb. 11 is a big setback for the Greek government's attempt to negotiate a new debt deal with its euro zone peers.
But an initial bout of heavy selling in Greek assets eased after the ECB agreed to allow the Greek central bank to offer lenders emergency funding of up to 60 billion euros -- an amount seen as offering enough to cushion a major run.
"The ECB are not politicians, and they won't want to pull the trigger on anything that would force Greece to leave the euro," said Rabobank strategist Lyn Graham-Taylor.
In a foretaste of the probable consequences of a prolonged deadlock between Athens and other EU capitals, short-term Greek bond yields shot up over 300 basis points to nearly 20 percent before pulling back to 17.3 percent.
Benchmark 10-year bond yields rose almost a full point to 10.87 percent but were unchanged on the day around 10 percent as market close approached.
Banking stocks were off their lows but remained 10 percent down on the day, driving the broader ATG equity index down by about 4 percent.
"As severe as the ECB announcement appears, it likely represents the central bank's opening gambit in what will be several rounds of negotiations with Athens and Berlin over the next four months," City Index chief global strategist Ashraf Laidi said.
Greek stocks were still above lows hit in the aftermath of Syriza's election victory less than two weeks ago, as investors perceive the left-wing party's leaders to have shown some openness to compromise as they tour Europe in search of allies.
The Greek central bank will have to provide lenders with tens of billions of euros of Emergency Liquidity Assistance in coming weeks, a step it takes at its own risk, ringfencing their funding problems from the rest of the euro zone.
Shares in National Bank of Greece and Bank of Piraeus both plunged more 13 percent on Thursday.
The ECB's decision came as Greek Finance Minister Yanis Varoufakis and his German counterpart Wolfgang Schaeuble clashed openly over Syriza's promises to scrap austerity imposed under Greece's bailout and negotiate a debt write-off.
Greek prime minister Alexis Tsipras meanwhile pledged to "put an end once and for all" to the EU's austerity policies.
Borrowing rates in the euro zone's weaker countries were only moderately affected, suggesting investors were not worried that the ECB's tough stance would prevent an eventual deal between Greece and its EU partners.
Italian and Spanish 10-year government bond yields rose around 5 bps in early trading but came back to be only a fraction higher on the day at 1.55 and 1.45 percent.
"I think the contagion effect should remain very limited. This is not yet the end of the world for Greek banks," said Patrick Jacq, rate strategist at BNP Paribas.
He said, however, that the liquidity situation for Greek banks might become "dangerous" if deposit outflows pick up. (Graphics by Vincent Flasseur; Editing by Catherine Evans)