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By Patrick Worsnip

UNITED NATIONS, Aug 29 (Reuters) - The outgoing U.N. Middle East envoy expressed "guarded optimism" on Wednesday about prospects for peace in the region because of growing Palestinian-Israeli dialogue and international involvement.

But Michael Williams told the Security Council in a final report after just three months in the job that continued diplomatic and practical steps were needed to stop a renewed peace process from running out of steam.

Following a visit to the region, "I returned guardedly optimistic, but conscious of many challenges ahead," he said.

Williams, a Briton, said a "substantive dialogue" developing between Palestinian President Mahmoud Abbas and Israeli Prime Minister Ehud Olmert and reform efforts by a new Palestinian government had "created growing expectations."

Abbas and Olmert met most recently on Tuesday.

The appointment of former British prime minister Tony Blair as an international Middle East envoy, an Arab peace initiative and preparations for a U.S.-sponsored conference in November on Palestinian statehood had helped, he said.

The "Quartet" of Middle East negotiators -- the United Nations, European Union, United States and Russia -- will meet in New York on Sept. 23 on the eve of the annual U.N. General Assembly gathering of heads of state and government.

The attempted relaunch of the peace process has been a paradoxical result of the takeover of the Gaza Strip by the Palestinian militant group Hamas from Abbas' forces in June.

Though the split has been deplored by Arab states and the United Nations, it enabled Abbas to fire the former Hamas-led Palestinian government, establish control in the West Bank and re-establish dialogue with Israel and the West.

But, Williams said, "The diplomatic process will need to be carefully monitored and supported, and must be buttressed by urgent and meaningful steps on the ground, if the many factors that could derail efforts are to be overcome."

GEAR SHIFT NEEDED

He said Israel needs to ease restrictions on movement in the West Bank and end incursions there, while the Palestinian Authority should deploy "credible security personnel" on the streets of West Bank cities.

He also said Israel should start to curb continuing Jewish settlement activity in the West Bank, which he said "undermines hopes for a contiguous Palestinian state."

Williams said talks must "shift gear, to achieve concrete agreements on permanent status issues and steps of implementation" -- a task that was not easy but "can be achieved."

"We cannot afford a new failure in the efforts to revive the Arab-Israeli peace process," Williams said. "There is hope now which has been absent for almost seven years. A setback at this stage could have serious consequences."

Williams, who succeeded Alvaro de Soto of Peru in the U.N. post in May, is to become British Middle East envoy for the new government of Prime Minister Gordon Brown. No replacement has yet been named.

Despite an exchange of accusations between Israel and Syria, Iran and some other Muslim states that is routine at Security Council Middle East debates, council president Pascal Gayama of Congo Republic said members felt there was movement.

"We think things can move slowly, provided there is good will for a diplomatic, political solution," he told reporters.

Williams told journalists that there could be Middle East progress later this year, but it was "over-ambitious" to expect a comprehensive settlement by then.

"The Palestinians would like to see a more ambitious agreement, a sort of framework agreement, which the Israelis perhaps are more reluctant to go for at this stage," he said.

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