(Updates with Abbas adviser comment)

By Nidal al-Mughrabi

GAZA, Nov 6 (Reuters) - Palestinian President Mahmoud Abbas and Prime Minister Ismail Haniyeh held talks on Monday that could lead to the formation of a unity government, potentially easing sanctions against the Hamas-led authority.

The two men held discussions in Gaza City for about two hours and broke off for the night. Officials said they would resume talks on Tuesday.

An Abbas aide who refused to be named said that during the talks the president had rejected Haniyeh's proposed candidate to succeed him as prime minister.

In New York, top Palestinian diplomat Riyad Mansour, the Palestinian observer at the United Nations, said agreement on a unity government could be reached on Monday, but the talks in Gaza proved to be more protracted.

"There are issues that require more discussion ... I hope that we will be able to conclude the remaining issues tomorrow or the following day," Abbas adviser Nabil Abu Rdainah said to reporters after talks ended for the night.

"All issues have been discussed and others are in need of more discussion. We have not yet reached an agreement but intensive efforts being exerted in this regard," Abu Rdainah added.

The talks came hours after a Palestinian woman blew herself up near Israeli troops in a Gaza town where Israeli forces had killed two women acting as human shields.

It was the first suicide bombing since April. One soldier was wounded, the army said.

Fatah leader Abbas and Haniyeh, a leader of Hamas, have held intermittent talks over recent months to try to forge a deal on a coalition government uniting their rival movements.

It was unclear exactly what sort of deal might be struck, but it was expected to see a new prime minister named in place of Haniyeh, officials said. A government spokesman said a candidate had been chosen but would provide no names.

One Hamas source said the current health minister in the Hamas-led administration, Basim Naeem, was a front runner, but an Abbas aide said the president had rejected him and asked the Islamist group to propose somebody else.

"Palestine is bigger than all of us," Haniyeh told a meeting of his cabinet in what sounded like a farewell speech. "It is very easy for us to move to another position in the interests (of our people)."

SUICIDE BLAST

Islamic Jihad claimed responsibility for the suicide bombing in Beit Hanoun in the northern Gaza Strip, where Israeli troops have been operating for the past six days in a bid to curb cross-border rocket attacks.

"Soldiers called on the woman to stop, then she blew herself up," an Israeli army spokesman said.

Relatives identified her as Mervat Masaoud, an 18-year-old student at Gaza's Islamic University. They said one of her cousins had blown himself up, along with another bomber, at Israel's Ashdod port in 2004 in an attack that killed 10 people.

On Friday, Israeli troops shot dead two women acting as human shields outside a mosque where gunmen had holed up in Beit Hanoun, witnesses said. The militants escaped.

The Israeli army said at the time it had fired at armed Palestinians and was investigating whether it had also shot the women. Since Israel began its operation in Beit Hanoun, 52 Palestinians have been killed, nearly half of them civilians. One Israeli soldier has also been killed.

In comments ahead of his meeting with Abbas, Haniyeh said Hamas wanted a unity government dedicated to "lifting the siege and ending the suffering of the Palestinian people".

But Hamas spokesmen have said the group will never recognise Israel or join a government that did, rejecting one of the main conditions set by the "Quartet" of Middle East peace brokers for renewing direct aid to the Palestinian Authority.

Hamas politician and senior leader Yahya Moussa announced on Sunday an agreement in principle with Fatah on a unity government of technocrats that would not be headed by Haniyeh.

In other violence in northern Gaza, Israeli air strikes killed two militants and a civilian, witnesses and hospital officials said. A civilian wounded on Friday died of his injuries in hospital.

After dark an unmanned military drone crash landed in Israeli territory near the Gaza Strip, an army spokesman said. He added that the circumstances of the crash were unclear and that investigators were examining the wreckage. (Additional reporting by Dan Williams and Ori Lewis in Jerusalem and Wafa Amr and Mohammed Assadi in Ramallah)

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