VILNIUS/BRUSSELS, June 29 (Reuters) - Trade through Lithuania to the Russian exclave of Kaliningrad could return to normal within days, two sources familiar with the matter said, as European officials edge towards a compromise deal with the Baltic state to defuse a row with Moscow.
Kaliningrad, which is bordered by European Union states and relies on railways and roads through Lithuania for most goods, has been cut off from some freight transport from mainland Russia since June 17 under sanctions imposed by Brussels.
European officials are in talks about exempting the territory from sanctions, which have hit industrial goods such as steel so far, paving the way for a deal in early July if EU member Lithuania drops its reservations, said the people, who declined to be named because the discussions are private.
The row over the Russian exclave's isolation is testing Europe's resolve to enforce sanctions imposed following Russia's invasion of Ukraine, fuelling fears of an escalation after other restrictions pushed Russia to default on its debt.
While Western powers have pledged to stand up for Ukraine, reiterating their resolve at both G7 and NATO summits this week, it is proving hard for Europe both to stand by strict sanctions and avoid further escalation with Russia.
That's why European officials, with the backing of Germany, are seeking a compromise to resolve one of their many conflicts with Moscow, said one of the people.
If the traditional route for Russian goods to Kaliningrad, first via its ally Belarus and then Lithuania, is not restored, the Baltic state fears Moscow could use military force to plough a land corridor through its territory, the person said.
Germany, meanwhile, has soldiers stationed in Lithuania and could be sucked into a confrontation alongside its NATO allies if that were to happen.
Europe's biggest economy is also heavily reliant on Russian gas imports and would be vulnerable to any reduction in flows if the Kaliningrad dispute escalated.
"We have to face reality," said one person with direct knowledge of the EU discussions, describing Kaliningrad as "sacred" for Moscow.
"(Putin) has much more leverage than we have. It's in our interests to find a compromise," he said, conceding that the eventual outcome may appear unfair.
COMPROMISE DEAL
A spokesperson for Lithuania's foreign ministry said it will continue to consult with the European Commission about the application of sanctions and that any change by the bloc should not single out the Baltic state.
"Sanctions must be enforced, and any decisions taken should not undermine the credibility and effectiveness of EU sanctions policy," the spokesperson said.
"As Kaliningrad transit is possible through various EU member states, the European Commission's explanation of how to implement the EU sanctions ... cannot be limited to Lithuania."
A spokesperson for the European Commission pointed to its June 22 statement that Lithuania was implementing EU restrictions and that the supply of essential goods to Kaliningrad remained unhindered.
One of the people with direct knowledge of the matter said they expected a compromise deal would be found by July 10 and a second person said it could be announced next week.
One compromise could see the movement of freight between Russia and Kaliningrad exempt from EU sanctions on the grounds it does not count as normal international trade because the exclave is part of Russia, said one of those people.
That concession could only be made on condition sanctioned freight is used in Kaliningrad and not exported via its port, where Russia's Baltic Fleet is headquartered.
That could be hard to guarantee and might put Lithuania, which is tasked with determining the end destination of goods, on a collision course with Russia, said the person.
Another person said humanitarian grounds could be used to carve out an exemption for Kaliningrad, which is sandwiched between Lithuania, Poland and the Baltic Sea.
He said, however, that Lithuania had serious reservations about making what could be seen as a concession to Moscow.
ALCOHOL AND CEMENT
Lithuania, formerly ruled from Moscow, is now one of Russia's fiercest critics in the European Union and has been at odds with officials in Germany and Brussels who want to defuse the row.
So far, EU sanctions against Russia prevent the transport of iron, steel and metals to Kaliningrad through EU states.
The list of sanctioned goods will extend to cement and alcohol from July 10, coal in August and oil products such as fuel in December. When the final phase kicks in, roughly half the freight sent to Kaliningrad from Russia will be sanctioned.
Neither passengers nor food products are banned and Kaliningrad can still be reached by plane or sea.
While the United States and European Union have promptly rolled out sanctions to curb Russia's access to international finance and its sales of coal and oil, the punitive measures have done little to temper Russian military aggression.
In recent weeks, Moscow has also turned the tables on Europe by paring back critical gas supplies, prompting Germany to brace for rationing and watch the escalating row over Kaliningrad with increasing apprehension.
Kaliningrad, which has a population of almost one million, was cut off from Moscow when Lithuania became independent during the break-up of the Soviet Union and residents must transit EU territory to reach the rest of Russia by land.
Dmitry Medvedev, deputy chairman of Russia's Security Council, said this week that curbs on the shipment of goods to Kaliningrad were part of a Western proxy war and that Russia had numerous ways to retaliate.
"There are many opportunities, a significant part of them are of an economic nature and are capable of cutting off the oxygen to our Baltic neighbours who have taken hostile actions," he told a Russian newspaper.
"There is also the possibility of using asymmetric measures, which ... will cause a critical escalation of the conflict."
