(Adds U.S. embassy statement)

By Ahmed Rasheed

BAGHDAD, March 3 (Reuters) - Prosecutors dropped charges on Monday against a former Iraqi deputy health minister accused of abusing his position to allow sectarian killings, a prosecution source and defence lawyers said.

Hakim al-Zamili, a member of powerful Shi'ite cleric Moqtada al-Sadr's political movement, was the first senior Iraqi official to face terrorism charges since the U.S.-led invasion to topple Saddam Hussein in 2003.

Zamili was being tried with Brigadier-General Hameed al-Shimari, the Health Ministry's former chief of security.

Several people had filed charges accusing the pair of corruption and masterminding the kidnappings and killings of their family members. Both men denied the charges.

The trial, which began on Sunday, was seen as a test case of the Shi'ite-led government's willingness to prosecute senior officials accused of fomenting sectarian bloodshed.

"The court has decided to release both Hakim al-Zamili and Hameed al-Shimari for lack of evidence. All testimonies heard by the court were not strong enough to convict them," a prosecution source said, speaking on condition of anonymity.

The U.S. embassy in Baghdad said after charges were dropped that parts of the trial appeared credible to outside observers but alleged witness intimidation and other "irregularities" meant U.S. officials reserved judgment on the decision.

It said the fact that the charges against Zamili and Shimari had been investigated and the pair had been tried reflected modest progress towards the rule of law in Iraq.

"However, there remain serious allegations of witness intimidation and other irregularities in this case that have not yet been transparently resolved within the Iraqi system," spokeswoman Mirembe Nantongo said in an e-mail to Reuters.

The prosecution source and defence lawyers said the two men had been escorted from the court by U.S. forces after the proceedings. A U.S. military official said later they were not in U.S. custody.

Zamili's lawyers, who had previously said both men were innocent, said the charges were dropped for a lack of evidence and witnesses.

"The court did not find a single piece of evidence on either of the two regarding the killings and kidnappings," Amir Taher, the head of Zamili's defence team, told Reuters.

"There were also no witnesses to testify they were involved in killing and kidnapping, so they are free to go," he said.

The pair were arrested by U.S. and Iraqi forces in February 2007 at the height of sectarian fighting between majority Shi'ites and minority Sunni Arabs that killed tens of thousands and threatened to tip Iraq into all-out sectarian civil war.

Officials at the time said Zamili had been held on suspicion he had infiltrated rogue members of Sadr's feared Mehdi Army militia into the health ministry.

He was also accused of helping funnel millions of dollars to Shi'ite militiamen. Zamili and Shimari could have faced the death penalty if found guilty. (Additional reporting by Mariam Karouny and Wisam Mohammed, writing by Paul Tait; editing by Andrew Roche)

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