By Christian Lowe

TAMARASHENI, Georgia, Aug 1 (Reuters) - Georgian engineer Josef Kalmakhelidze says it is not easy building a children's funfair in a battle zone.

"We could not get any work done for two or three days because they were shooting at us," he said, breaking off from installing a brightly-painted ferris wheel and looking up at a sandbag-covered dugout on the hillside above him.

Fifteen years after it lost control over its South Ossetia province in a separatist war, Georgia is pushing hard to get it back and the funfair -- along with a hotel, fitness centre and swimming pool also under construction -- is one of the weapons in its charm offensive.

Thousands were killed in 1990s fighting over this sliver of land, 100 km (60 miles) north of Georgia's capital. A ceasefire is in force but there are almost weekly gunbattles between separatists and Georgian forces.

The conflict is an open sore in relations between Georgia's Western-backed government and its neighbour Russia: Moscow has peacekeeping troops in South Ossetia, and Tbilisi accuses them of siding with the separatists.

Georgian President Mikhail Saakashvili has a twin-pronged approach. In a direct challenge to the separatists, he has set up a rival South Ossetian government, led by Dmitry Sanakoyev, a former separatist prime minister who switched sides.

Saakashvili is funnelling large sums of cash into a cluster of villages inside South Ossetia that remain under Georgian control. "There is a battle for hearts and minds going on," Saakashvili told his ministers last month.

RISE IN TENSIONS

Much of the new construction is in the village of Tamarasheni, a short walk from the separatists' capital, Tskhinvali. A cinema, so new its seats are still wrapped in plastic, stands gleaming on the village's only street.

The contrast is striking. In Tskhinvali, the buildings are old and decaying and the main entertainment venue, the theatre, has no roof after an accidental fire.

But some observers say Saakashvili's strategy could trigger a new war. In June, the two sides exchanged artillery fire for three days in the biggest flare-up for months and crowds of Georgian villagers confronted Russian peacekeepers.

"The Georgian government's steps are non-violent ... but they are contributing to a perceptible and dangerous rise in tensions," said an International Crisis Group report. "Frequent security incidents could degenerate into greater violence."

Violence, or the threat of it, is never far away in South Ossetia.

In the lobby of Tamarasheni's new cinema stand cardboard cutouts of Hollywood stars Brad Pitt and Julia Roberts. Next to them, a man in camouflage gear sleeps on a metal cot. His automatic rifle is tucked under his pillow.

When Sanakoyev tours his tiny domain, he is accompanied by four thick-set bodyguards in bullet proof vests. He says he has received threats from his former separatist comrades.

PEOPLE DYING

"The international community and Russia are not ready to accept South Ossetia as a sovereign state. And without recognition our people are dying," the 38-year-old Sanakoyev told Reuters in his temporary headquarters, a converted wing of a hospital.

"The only way we can (develop) is if we live as part of Georgia and have the attributes of a state. Georgia today is prepared to allow us to do that."

Some people are tempted by this message. Znaur Gassiyev, speaker of the separatist parliament, called Sanakoyev a "Judas". But he added: "I know some people ... even in my own entourage, who are wavering," he said. "(They think) 'Let's see. If things go well for Dima, we can join him'."

Another separatist official said Tbilisi, by presenting Sanakoyev to the world as South Ossetia's legitimate leader, could muddy Tskhinvali's claims for international recognition.

But for most people in Tskhinvali, mistrust of Georgia is too entrenched for them to be wooed by cinemas and funfairs.

"Their aim is to split South Ossetian society," said Alan, who was talking to a friend opposite the town's burned-out theatre. "I am more than 100 percent sure it will not work.

"I am unemployed at the moment but in spite of that I will never agree to work for (Sanakoyev's) government," he said. "They are criminals ... The Georgians just take them around and display them like monkeys at the zoo."

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