(Adds closing shilling rate)

By Helen Nyambura-Mwaura and George Obulutsa

NAIROBI, Jan 7 (Reuters) - The Kenyan shilling <KES=> closed slightly weaker on Monday, but traders said sentiment was for a stronger local currency after the opposition cancelled nationwide protests over President Mwai Kibaki's disputed election win.

Commercial banks quoted the shilling closing at 66.65/67.05 to the dollar from an open of 66.00/50 -- buoyed by opposition leader Raila Odinga's move to give mediation a chance.

The news also lifted the Nairobi Stock Exchange, which recouped some of last week's losses on Monday. The bourse's 20-share index <.NSEK> gained 3.3 percent to settle at 5,180.14 points after shedding 7.89 percent last week amid running battles between police and anti-government protesters.

The shilling touched an intraday low of 67.10/30 before Odinga -- who says Kibaki rigged his re-election -- called off the mass action.

"It is now business as usual. We are back to a stronger shilling," said Chris Muiga, a senior dealer with Kenya Commercial Bank. "We'll see strengthening of the shilling on the back of this announcement."

Market players are hoping for some respite to the turmoil in east Africa's biggest economy that has killed nearly 500 people since the Dec. 27 vote.

Commercial banks posted interbank prices for the first time in the new year on Monday, reversing an earlier decision designed to prevent the shilling from spiralling.

"Liquidity is coming back to the market," said Friday Mwafuga, head of trading at the Cooperative Bank. "The market is getting confident so spreads are reducing to between 30 and 50 cents."

The shilling fluctuated sharply last week in thin volumes and a wide range. In offshore trading, the local unit weakened to 68.50 against the dollar at one stage last week, hitting an eight-month low according to Reuters data.

Stock brokers expect a rally in coming days as relative calm returns to the tea- and coffee-growing nation.

"The market looks very strong," said Aly-Khan Satchu, head of Rich Management, a stock market data vendor.

"All the bad news is (factored) in the price. Any positive news will see a lot of buying interest."

In another sign that Kenya was slowly getting back to normal, the country's weekly tea auction resumed on Monday.

"Today there will be an auction. We hope this will begin to stabilise the market," said Lerionka Tiampati, managing director of the Kenya Tea Development Agency (KTDA), which represents small holder farmers who contribute more than 60 percent of the country's output.

Tiampati said most small-scale tea farmers had been unaffected by the violence and were able to transport their leaves to the auction in Mombasa, thanks to security provided by the government.

The auction also serves other tea producers including Uganda, Tanzania, Rwanda, Burundi and Mozambique among others.

But coffee buyers will still have to wait a week for the resumption of their sale, which is usually held in the capital every Tuesday. Unrest in the country had forced the Nairobi Coffee Exchange to postpone its first auction of the year, scheduled for Jan. 8, by a week. (Additional reporting by Katie Nguyen; editing by Stephen Nisbet)

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