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By Margarita Antidze

MEGVREKISI, Georgia, Aug 7 (Reuters) - Georgia pounded the capital of its breakaway South Ossetia province with heavy weapons on Thursday after a ceasefire broke down within hours and separatists said they were under siege.

"Georgian troops are storming Tskhinvali (the capital). They are bombing the city," South Ossetia's separatist leader, Eduard Kokoity, told Russian news agencies.

A Reuters reporter saw intense fire from heavy weapons at different locations skirting Tskhinvali. The reporter heard heavy fighting coming from the direction of the city.

The night sky was lit up blue and red by explosions and Georgian forces appeared to be firing Katyusha rockets.

"We have an operation under way to neutralise separatist positions from which they are shelling Georgian villages," a senior interior ministry official told Reuters in the Georgian capital, Tbilisi.

The commander of Georgian peacekeepers in South Ossetia, Mamuka Kurashvili, told Georgian television: "We are forced to restore constitutional order in the whole region."

Skirmishes since the weekend have deepened fears of full-blown conflict in the Caucasus, which is emerging as a vital energy transit route and where Russia and the West are vying for influence.

South Ossetia and a second rebel Georgian region, Abkhazia, --both of which unilaterally broke away from Georgia at the beginning of the 1990s -- enjoy Russian political and financial backing, ex-Soviet Georgia has allied itself with the West and is pushing for NATO membership.

Georgian President Mikheil Saakashvili earlier on Thursday offered the separatists an immediate ceasefire following fighting in which Tbilisi said up to 10 Georgian peacekeepers and civilians had been killed.

Fighting stopped on Thursday afternoon after Saakashavili said he had instructed troops to stop returning fire and Moscow said the two feuding sides would hold talks on Friday.

But artillery fire broke out again with nightfall. Friday's meeting looked inceasingly unlikely to go ahead.

"MERCENARIES" HEAD TO REGION

Russia's envoy said Georgia's military operation showed it could not be trusted and NATO should reconsider its plans to grant membership to the ex-Soviet state, Interfax news agency reported.

"Georgia's step is absolutely incomprehensible and shows that the Georgian leadership has zero credit of trust," said the envoy, Yuri Popov, who was dispatched to the region on emergency.

Officials had said Thursday's fighting killed up to 10 Georgian soldiers and civilians, and two Ossetian civilians.

A Georgian security source told Reuters Georgia had moved special police units and an army brigade up to the town of Gori, on the edge of South Ossetia. A military field hospital had been set up and some civilians were seen leaving for Gori.

The Georgian government said it had information about "hundreds of mercenaries, tanks and other equipment" entering South Ossetia through the Roki tunnel from Russia. A government official said Russian army units were also approaching.

Interfax news agency said hundreds of volunteers from Russia and Abkhazia were heading for South Ossetia on Friday to support the separatists.

The United Nations and European Union appealed for calm.

EU foreign policy chief Javier Solana discussed the situation by telephone with Saakashvili.

"Solana expressed his serious concern about the situation in South Ossetia and called for every effort to be made to rapidly end the violence and resume peaceful talks between the sides," an EU statement said.

Fitch's head of emerging European sovereigns, Edward Parker, told Reuters prolonged warfare could prompt the ratings agency to downgrade Georgia from its current BB-rating with stable outlook and have an impact on foreign investment.

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