(Recasts, adds quotes, details and background)

By Arshad Mohammed

WASHINGTON, Aug 17 (Reuters) - The United States said on Friday it was considering putting Eritrea on its list of state sponsors of terrorism for allegedly funneling weapons to insurgents fighting the Ethiopian-backed government in Somalia.

Putting Eritrea on the list would impose sanctions on the Horn of Africa nation, including a ban on arms-related sales, prohibitions on some U.S. aid and U.S. opposition to International Monetary Fund and World Bank loans to Eritrea.

The fragile interim Somali government, backed by troops from Eritrea's archrival Ethiopia, is fighting an Islamist insurgency in a conflict that has killed hundreds of people since December.

A U.N. monitoring group last month said large quantities of arms, including surface-to-air missiles, were flowing from Eritrea to Somalia. Eritrea has denied sending the weapons.

Diplomats say Eritrea and Ethiopia have been waging a proxy war in Somalia since last year, when Asmara backed a hard-line Islamist movement against the country's government.

U.S. Assistant Secretary of State Jendayi Frazer said Eritrea could avoid being designated a state sponsor of terrorism if it stopped its alleged activities in Somalia.

"We are not looking to go down this route but if they continue their behavior and we put together the file that's necessary, I think it would be fairly convincing," she told reporters.

Frazer said the United States had intelligence that backed up the U.N. report.

"We are still in the process of collecting that data and ... it's an opportunity -- before they are put on the state sponsors list -- for them to change their behavior," she said.

U.S.-Eritrean relations have long been strained.

The United States earlier this month decided to close the Eritrean consulate in Oakland, California, to demonstrate its unhappiness both over Somalia and over Eritrea's treatment of U.S. diplomats in Asmara.

The United States says Eritrea has insisted on inspecting its diplomatic pouches and refused visas for U.S. diplomats, making it difficult for the United States to provide consular services in Eritrea.

"We have tried our best to act with restraint with Eritrea," Frazer told reporters. "What we cannot tolerate is their support for terror activity, particularly in Somalia.

"Closing their consulate is a major signal to the government of our seriousness in terms of the activities that they are carrying out in Somalia," she said.

However, she suggested the United States did not wish to sever diplomatic ties, saying, "We are not trying to move toward a fundamental break in our relationship."

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