* Fertilizer used in bombs in Afghanistan
* Aid freeze could further hurt U.S. ties with Pakistan
* Porous border, corruption make smuggling easy (Adds Foreign Ministry, paragraphs 16-17)
By Michael Georgy and Rebecca Conway
ISLAMABAD, Dec 13 (Reuters) - A crisis in relations looked set to deepen after a U.S. House-Senate negotiating panel agreed to freeze $700 million in aid to Pakistan until it gives assurances it is helping fight the spread of improvised explosive devices in the region.
Pakistan is one of the largest recipients of U.S. foreign aid and the cutback announced is only a small proportion of the billions in civil and military assistance it gets each year.
But it could presage greater cuts as calls grow in the United States to penalise Islamabad for failing to act against militant groups and, at worst, helping them, following the secret U.S. raid on a Pakistan military town in which al Qaeda leader Osama bin Laden was killed.
Home-made bombs or improvised explosive devices (IEDs) are among militants' most effective weapons against U.S. and coalition troops in Afghanistan as they struggle to fight a resurgent Taliban insurgency.
Many are made using ammonium nitrate, a common fertilizer smuggled across the border from Pakistan. The freeze on U.S. aid was agreed as part of a defence bill that is expected to be passed this week.
The United States wants "assurances that Pakistan is countering improvised explosive devices in their country that are targeting our coalition forces", Representative Howard McKeon, a House Republican, told reporters.
The United States has allocated some $20 billion in security and economic aid to Pakistan since 2001, much of it in the form of reimbursements for assistance in fighting militants.
But U.S. lawmakers have expressed increasing frustration with Pakistan's efforts in the war.
There have been numerous proposals to make U.S. aid to Pakistan conditional on more cooperation in fighting militants such as the Haqqani network Washington believes operates out of Pakistan and battles U.S. troops in Afghanistan.
But Pakistan's civilian leaders have in the past warned against aid cuts, saying it would only harden public opinion against the United States.
Pakistan says it is doing all it can to fight al Qaeda and the Taliban and has lost thousands of soldiers since it joined the U.S.-led war in 2001, some of them at the hands of coalition troops.
Islamabad has accused NATO of deliberately killing 24 Pakistani soldiers in an air strike near the Afghan border last month and shut down supplies for foreign troops in Afghanistan in anger.
The decision to freeze aid could prompt Pakistan to harden its stance towards Washington.
"I think the Pakistan side will understand the type of signal that is coming, which shows it's not only a question of aid," said former general and security analyst Talat Masood.
"The whole attitude of the U.S. and the relationship will be affected by these measures because they know Pakistan will not be in a position to control the smuggling."
Pakistan's foreign ministry spokesman, Abdul Basit, suggested pressure from the United States would hurt ties.
"We believe in cooperative approaches rather than doing things which can only complicate matters," he said.
U.S. lawmakers said that many Afghan bombs are made with fertilizer smuggled by militants across the border from Pakistan into Afghanistan.
"The vast majority of the material used to make improvised explosive devices used against U.S. forces in Afghanistan originates from two fertilizer factories inside Pakistan," Senator John McCain, a Republican, said in the Senate last week.
A Congressional Research Service report in October said the Pakistani factories, owned by one of the country's biggest companies, Pakarab, have been producing over 300,000 metric tonnes of ammonium nitrate per year since 2004.
The United States has urged Pakistan to strictly regulate the distribution of ammonium nitrate to Afghanistan. So far, Pakistan has only produced draft legislation on the issue.
Analysts say U.S. demands will be tough to meet because of rampant corruption on both sides of the porous border which makes smuggling easy.
One businessman explained how easy it is to get through security.
"We pay a 1,200-rupee ($13) bribe to the Pakistani Frontiers Corps on the border for every car carrying fertilizer," said Kamal Khan in the border town of Chaman.
"Fertilizer is smuggled on trucks, pickup trucks, motorcycles, bicycles and donkey carts."
Pakistan's fragile economy is heavily dependent on agriculture so cutting down on fertilizer output would hurt the sector.
"If you say, 'ok you can only produce these ureas and you cannot produce the nitrates' it means you are going to impose unrealistic terms on Pakistan," said Amir Rana, director of the Pakistan Institute for Peace Studies.
The provision freezing $700 million in aid was agreed upon by leaders of the armed services committees from both parties in the House and Senate, including McCain. It is part of compromise legislation authorizing U.S. defense programs expected to be approved this week, McKeon said.
He said the bill would also require the Pentagon to deliver a strategy for improving the effectiveness of U.S. aid to Pakistan.
Additional reporting by Saeed Ali Achakzai in CHAMAN and Susan Cornwell in WASHINGTON; Editing by Sanjeev Miglani