(Adds Bulgarian foreign minister, background)

By Salah Sarrar

TRIPOLI, July 17 (Reuters) - Libya lifted death sentences on Tuesday against five Bulgarian nurses and a Palestinian doctor convicted of deliberately infecting children with HIV, paving the way for them to be freed after eight years in jail.

The ruling, following a payment of $1 million each to 460 HIV victims' families, fell short of freeing the medics and removing an obstacle to Libyan leader Muammar Gaddafi's efforts to end three decades of diplomatic isolation.

But, under a 1984 prisoner exchange agreement with Libya, the North African country can transfer the six workers to Bulgaria, where government officials have said they could be pardoned by the Balkan state's president, Georgi Parvanov.

"The High Judicial Council decided to commute the death sentences against the five Bulgarian nurses and the Palestinian doctor to life-imprisonment terms," Libya's High Judicial Council said in a statement.

The six were sentenced to death last year after being convicted of intentionally starting an HIV epidemic at a children's hospital in the Mediterranean port of Benghazi.

The medics say confessions central to their case were extracted under torture and that they are innocent, while Bulgaria and its allies, the United States and the European Union, have demanded the nurses be freed.

"Tomorrow morning we will start working on implementing the transfer of the medics," Bulgarian Foreign Minister Ivailo Kalfin told reporters in Sofia. "For us the case will end once they come back to Bulgaria."

Foreign HIV experts testified during the case in Libya that the infections started before the six arrived at the hospital and were more likely to be the result of poor hygiene.

But the victims' families have said the case was part of a Western attempt to undermine Muslims and Libya. Fifty-six of the children have died, arousing widespread anger there.

STILL NOT OVER

Bulgaria, the EU and the United States say Libya has used the medics as scapegoats to deflect criticism of its dilapidated health care sector.

In the United States, where President George W. Bush is planning to send the first U.S. ambassador to Libya in nearly 35 years, a senior official said the ruling was "a positive step forward", but not an end to the ordeal.

"We are encouraged at the commutation of the death sentences and we hope they will result in a way to let the medics return home," said senior State Department official David Welch.

Reaction among the nurses' families in Bulgaria was one of cautious hope. The nurses left the relatively poor country of 7.8 million people in the late 1990s to work in Libya, where health-care salaries are much higher.

"I feel good. But I will feel even better when I see them come at the airport," said Zorka Anachkova, mother of nurse Christiana Valcheva. "The burden will not fall from my heart until I see them home."

A spokesman for the Libyan children's families, Idriss Lagha, said the funds for the financial settlement had come from the Benghazi International Fund, which had been financed by the European Union, the United States, Bulgaria and Libya.

The case has hit the residents of Benghazi particularly hard, and virtually every extended family there has a relative or close friend infected in the epidemic.

But Lagha said the families' acceptance of the payout implied they had dropped their complaint against the medical workers.

"My personal interpretation is that their move is the equivalent of a pardon because the compensation money is the equivalent in Islam to 'blood money', which entails pardon," Lagha said.

Sofia's western allies have suggested that not freeing the nurses would hurt Gaddafi's efforts to emerge from isolation, a process he began by scrapping a prohibited weapons programme in 2003.

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