(Adds Gaza air strike paragraph 11, protest)

By Rebecca Harrison

JERUSALEM, May 8 (Reuters) - Israel celebrated its 60th birthday with barbecues and military display on Thursday but the party was marred by an investigation that could unseat the prime minister and derail efforts toward a peace it has never known.

Blue-on-white Star of David flags fluttered from cars, rooftops and balconies, fighter planes traced "60" in smoke trails across the sky, paratroopers dropped into the sea and a televised youth Bible quiz highlighted the place Jewish faith holds in a state mainly founded by secular Zionists.

War or the threat of it has clouded every day for Israelis since David Ben-Gurion declared their state in 1948 that was destined to be a haven for survivors of the Nazi Holocaust.

On Thursday, families gathered to focus on the positive and on national pride. "It's an emotional day," said Tzviya Gilboa, 57, among vast crowds packing sunny beaches at Tel Aviv. "Anything that is connected to Israel is exciting to me."

Keren Yohanan, 35, attended a barbecue at her cousin's home near Jerusalem. "I'm happy that Israel is 60," she said. "There is excitement but I am simply happy for what we have in Israel."

Fireworks, light shows and military fanfare launched celebrations on Wednesday and Prime Minister Ehud Olmert, who is pursuing a deal for a Palestinian state alongside Israel, said the Jewish state craved an end to the decades-old conflict.

"In the state of Israel's 60th year, we can say that God has fulfilled his promise," Olmert said on Thursday, hours before police said they expected to ease sweeping restrictions on reporting details of the investigation into his affairs.

"We, the descendants of Abraham, have inherited the land, we have filled it, we have made the desert bloom, built and made it glorious," he said. "The spirit of sacrifice still beats within us and is still sadly setting us trials that are hard to bear."

Israel's most important ally and the chief sponsor of peace talks launched six months ago, U.S. President George W. Bush, visits next week. So do top executives from Google and Yahoo -- testament to Israel's success as a technology powerhouse.

Security was intense for fear of attacks and armed police guarded revellers on the beaches. Measures to stop Palestinians entering Israel from Gaza and the West Bank were tightened.

Six Islamic Jihad militants were wounded in an Israeli air strike in the Hamas-controlled Gaza Strip, medical staff said.

SOLEMN MARCH

While Israelis partied, Palestinians held a solemn march in Bethlehem to mark the "nakba", or catastrophe, of the Jewish state's creation, when about 700,000 people, half the Arab population of Palestine, fled or were driven from their homes.

Holding banners vowing never to give up their "right to return" to land now part of Israel, protesters rallied around a 10-metre-long key, a symbol of the dream to reclaim lost homes.

"It hurts me dreadfully to see Israel celebrating because of our suffering, our expulsion and the loss of our homeland," said Monther Amireh, as Israeli planes roared overhead.

In northern Israel, thousands wearing black armbands and waving Palestinian flags rallied at a site where an Arab village once stood. It is now a Roman-era archaeological site.

Israel's festivities were clouded by the police investigation into Olmert's affairs that has aroused speculation he may have to quit, upsetting peace talks already beset by squabbles over Jewish settlements and violence in Gaza.

Already the focus of a series of corruption scandals in which he has denied any wrongdoing, Olmert was questioned at short notice by police on Friday over fresh allegations.

Washington said Olmert was a "very important" player in the peace process but noted he was not Israel's only representative. Foreign Minister Tzipi Livni, seen as the likeliest successor to Olmert within his Kadima party, leads Israel's negotiating team.

Founded on the basis of Jewish claims to biblical land and as a haven for survivors of European persecution that culminated in the Holocaust, Israel declared independence on May 14, 1948.

Israelis celebrate the day according to the Jewish calendar.

(Additional reporting by Brenda Gazzar in Jerusalem, Avida Landau and Ari Rabinovitch in Tel Aviv and Mohammed Assadi in Bethlehem; Editing by Alastair Macdonald) For more stories on Israel's 60th anniversary double click on [IDn:nL0655523] For multimedia coverage visit: http://uk.reuters.com/news/globalcoverage/middleeast?refresh=true

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