(Adds Olmert comments, details, background)

By Rebecca Harrison and Avida Landau

JERUSALEM, Feb 3 (Reuters) - Israeli Defence Minister Ehud Barak said on Sunday he would not quit the government despite a harsh Lebanon war report, relieving pressure on Prime Minister Ehud Olmert as he pursues peace talks with the Palestinians.

The Labour party leader had suggested he might pull out of Olmert's fractious coalition if an official inquiry into the 2006 Lebanon war released last week blamed the prime minister directly for political and military bungles.

But Barak, whose departure would likely have felled the government and prompted snap polls, said he would stay in the job to deal with recommendations laid out by the Winograd Commission and would later "set a date for elections".

"I decided to stay," Barak told reporters ahead of a cabinet meeting in remarks aired on Army Radio. "And why am I staying? I remain in my job as defence minister because I know the challanges that face Israel."

Israel's war against Hezbollah guerillas pummelled Olmert's approval ratings and his political rivals had been positioning themselves for a resignation. Barak has been keen to distance himself from a government he joined about a year after the war. But although the report, released on Wednesday, was scathing about Israel's political and military failings, it was widely regarded as a personal reprieve for Olmert, who once described himself as "indestructible".

Olmert, who has also been plagued by a string of graft allegations which he denies, has hinted he will stay on to fix the problems highlighted by the report. He described it on Sunday as "difficult" but also a "source of opportunity".

"(It is) an opportunity to fix things that were uncovered, to improve them, to rebuild, and to lead Israel forward in order for it to be well prepared," Olmert told reporters ahead of Sunday's cabinet meeting.

Barak, who leads Israel's centrist Labour party, is widely seen as a future political challenger to Olmert but most observers believe he needs more time to build a support base before pushing for elections.

A former general, Barak served as prime minister from 1999 to 2001.

Israel and the Palestinians agreed in November to restart peace talks after a seven-year hiatus but Olmert's fractious coalition and his own fragile political standing were regarded as hobbling the peace drive.

Olmert's allies have said the prime minister had been exonerated and would now focus on building a broader coalition better placed to pursue negotiations, which will need to tackle divisive issues for Israelis such as the future of Jerusalem. (Writing by Rebecca Harrison)

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