By Barry Moody and Daniel Wallis

ADDIS ABABA, Jan 31 (Reuters) - U.N. chief Ban Ki-moon warned of catastrophe in Kenya on Thursday when an African summit opened in Ethiopia, with discussions dominated by the crisis in the once stable neighbouring nation.

At least 850 people have died and 250,000 fled their homes in Kenya since the disputed re-election of President Mwai Kibaki in a Dec. 27 poll.

"Violence continues, threatening to escalate to catastrophic levels," Ban said at the beginning of a three-day African Union summit, adding that Kibaki and opposition leader Raila Odinga must do everything possible to resolve the crisis.

Ban called on the summit to "urge and encourage the leaders and people of Kenya to calm the violence and resolve their differences through dialogue and respect for the democratic process."

Alpha Oumar Konare, the AU's top diplomat, shared the concern over Kenya, saying it "had been a country of peace that had urged others to talk peace. If Kenya burns, what is left?"

Until a month ago, Kenya was more used to attending summits of the 53-nation AU as a respected regional peacemaker and a refuge for those fleeing wars in neighbouring countries.

Now it is Africa's biggest crisis, torn by a cycle of ethnic bloodshed that threatens to destabilise a key regional ally of the West and damage the economies of a swathe of neighbouring countries.

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In the latest bloodshed, the Kenyan opposition said a second of its legislators had been shot dead on Thursday in the Rift Valley town of Eldoret.

Senegal's President Abdoulaye Wade said in Addis Ababa that Kenya should be top of the summit agenda.

"It is unacceptable that right next to us, thousands of people are dying and that we should just come here and then leave without making our voices heard," he told Radio France International (RFI).

"It is Africa's image which is at stake in this Kenya affair."

Kibaki arrived for the summit early on Thursday but made no comment.

He has only been recognised by a small number of African countries, but Ethiopian sources said a delegation from Odinga's Orange Democratic Movement had been told they would not be allowed into the summit, following AU practice of only admitting standing governments.

Wade said he had spoken to Odinga and believed he should be allowed to come to Addis Ababa and address a message to the summit-something vehemently opposed by Kibaki's government.

Kenya's crisis presents the AU with the dilemma of either breaking with its traditional reluctance to interfere in the internal affairs of its members, or being seen as ineffectual in addressing the continent's most pressing problem.

An early mediation mission by outgoing AU chairman John Kufuor, the president of Ghana, failed.

He handed over to Ban's predecessor, Kofi Annan, who has succeeded in bringing Kibaki and Odinga together for early negotiations.

A second round of talks between the two sides were planned on Thursday but a solution still seems far off despite heavy pressure from Western powers alarmed by the crisis. (Additional reporting by Pascal Fletcher in Dakar, editing by Philippa Fletcher)

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