* Bomber targets Kurdish funeral in disputed town

* Attack likely to increase Kurd-Arab tension

(Adds reaction from Kurdish lawmaker)

SULAIMANIYA, Iraq, March 23 (Reuters) - A suicide bomber blew himself up at a Kurdish funeral in the volatile and ethnically mixed province of Diyala in northern Iraq on Monday, killing 25 people and wounding 45, police said.

The bombing in the town of Jalawla, 115 km (70 miles) northeast of Baghdad, highlighted the dangers Iraq still faces from militants, even as overall violence falls to levels not seen since mid-2003 and the United States prepares to withdraw combat troops by Aug. 31, 2010.

"We heard a huge explosion. We looked over at our neighbour's house and there were dead people everywhere," said Suhad Ahmed, a woman who lives next door to the house where the blast occurred.

Diyala is a melting pot of Kurds, Arabs and Turkmen variously professing Sunni, Shi'ite, Christian and other faiths.

Tension between Arabs and Kurds in the province has been rising, driven by disputes over oil and territory between Iraq's Shi'ite Arab-led government in Baghdad and officials in the largely autonomous Kurdistan region.

Jalawla lies on the disputed border between Kurdistan and the rest of Iraq and was one of several towns where there were standoffs between Iraqi central government forces and Kurdish Peshmerga fighters last year.

By bombing a Kurdish event, the militants could be trying to spark ethnic conflict between Arabs and Kurds, just as Sunni Islamist militants from al Qaeda provoked a conflict between Shi'ite and Sunni Arabs in 2006 and nearly tore Iraq apart.

Under a deal between Baghdad and Kurdistan last year, the Peshmerga agreed to withdraw from Jalawla and let Iraqi forces take over. Kurds complain that security has worsened since then.

"When the Peshmerga were in Jalawla, the terrorists could not attack civilians. If they were still there, this would not have happened," Saadi al-Barazanchi, a member of the Kurdish alliance in Baghdad's parliament, told Reuters.

Earlier on Monday, a bomb at a west Baghdad bus terminal killed nine people and wounded 23, Iraqi police said. It was the second bomb attack this month in the predominantly Sunni Arab district of Abu Ghraib.

U.S. officials say the Iraqi police force and army, now stronger and more professional, have helped foil many bombing attempts but checkpoints cannot stop every bomber. (Additional reporting by Wisam Mohammed in Baghdad; Writing by Tim Cocks, Editing by Andrew Dobbie)

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