(Updates with heavy clashes at dusk)

By Nazih Siddiq

NAHR AL-BARED, Lebanon, May 29 (Reuters) - The Lebanese army launched artillery shells at a Palestinian refugee camp on Tuesday and militants barricaded inside fired mortars in the heaviest fighting there in a week.

As dusk fell, the rattle of heavy machine gun fire was also heard at the Nahr al-Bared camp -- the base of militant group Fatah al-Islam which is surrounded by the Lebanese army.

"Clashes are expected," a military source said. "It's an open front." Smoke was seen rising from buildings inside the camp, a maze of alleyways which was home to 40,000 before the fighting began. Thousands of Palestinians have fled.

One Lebanese soldier was killed early on Tuesday, bringing the death toll in Lebanon's worst internal fighting since the 1975-1990 civil war to at least 79 people -- 34 soldiers, 27 militants and 18 civilians.

The Lebanese government says Fatah al-Islam triggered the fighting when it attacked army positions around the camp and the northern city of Tripoli on May 20. It has demanded the militants surrender.

Fatah al-Islam say they have been acting in self defence and reject the demand to hand over any of their fighters.

A 1969 Arab agreement stops the army from entering Lebanon's 12 Palestinian refugee camps, home to 400,000.

The government has given Palestinian leaders in Lebanon a chance to find a way out of the standoff, concerned that the refugees will see more army action at the camp as an attack on their community.

"The Palestinians' blood is too hot to handle and we cannot bear the consequences of spilled blood. We are not in this battle to attack Palestinians but to repel an attack against Palestinians and Lebanese," Prime Minister Fouad Siniora said.

The prospect of a decisive military solution to the standoff has been played down by the government in recent days because it could trigger violence at the other refugee camps, even though Fatah al-Islam has little support among Palestinians.

NO PROGRESS TOWARDS SOLUTION

The Palestinian leaders have outlined a plan to end the standoff and are communicating with Fatah al-Islam through clerics in the camp.

But a Palestinian mediator, who asked not to be identified, said there had been no progress towards a solution. "There is a need to move quickly but that is not happening," he said.

He said the crisis could deepen if it not resolved soon because the militants and their sleeper cells "will get the chance to catch their breath and launch attacks elsewhere. The Lebanese government must find a way out".

Members of Lebanon's anti-Syrian cabinet have described Fatah al-Islam as a tool of Syrian intelligence, though Damascus denies any links to the group.

"The first concern for the government and army is to remove the Palestinian civilians from inside the camp. After that the army will deal with Fatah al-Islam," Saad al-Hariri, head of the ruling government coalition bloc, told the pan-Arab al-Sharq al-Awsat newspaper.

"There will be no negotiations with those terrorists who came to Lebanon to carry out the orders of Syrian intelligence."

Lebanese authorities say Fatah al-Islam includes Arabs from Saudi Arabia, Algeria, Tunisia, Syria and Lebanon. (Additional reporting by Nadim Ladki and Tom Perry in Beirut)

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