* Talks produce agreement to form inclusive government

* Former heads of state eligible to stand in election.

By Alain Iloniaina

ANTANANARIVO, May 23 (Reuters) - Madagascar's feuding leaders have agreed to form an interim unity government in a breakthrough that could pave the way to ending a political crisis, a U.N. official said.

Describing the agreement as progress, special envoy Tiebile Drame said late on Friday the Indian Ocean island's main political parties also agreed that former heads of state could stand in the next presidential election.

Political instability has racked the world's fourth largest island since the beginning of 2009, devastating its $390-million-a-year tourist industry and worrying foreign companies exploring its oil and mineral riches.

"The parties have agreed on the institutions of a transitional administration. The High Transitional Authority will comprise of: an interim government of national union, a transitional congress, a national reconciliation council and an independent national electoral commission," Drame said.

The deal, reached after three days of talks with African Union and Southern African Development Community officials, would allow new army-backed President Andy Rajoelina and ousted leader Marc Ravalomanana to contest an election.

The international community has put pressure on Rajoelina to hold a ballot this year. However, Drame said the rivals had agreed on a time of no more than 14 months from the signing of the transitional authority's charter.

Rajoelina, 34, who is six years too young to be president under the existing constitution, seized power with the support of dissident troops in March.

The entrepreneur and former disc jockey has said he will rewrite the constitution and electoral code before pressing ahead with election plans.

Foreign leaders and regional blocs branded Rajoelina's power grab a coup. Several donors including the International Monetary Fund, the United States and Norway suspended non-emergency funding.

Ravalomanana, who insists he remains the legitimate leader but is now in exile in South Africa, has said he intends to return to the island within weeks.

Rajoelina's government accuses the self-made millionaire of tax evasion amounting to millions of dollars and still has an arrest warrant out for him.

Drame suggested the pact would allow Ravalomanana's return: "A special statute safeguarding the dignity and guaranteeing the security of former heads of state will be drawn up."

He said the next step was to agree on the division of power and responsibility in the transitional institutions. (Writing by Richard Lough; Editing by David Clarke)

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