(Adds comments from interim leader, military)

By Anis Ahmed

DHAKA, Dec 17 (Reuters) - Bangladesh lifted a two-year-old state of emergency on Wednesday ahead of a parliamentary election this month aimed at restoring democracy in the impoverished South Asian nation.

President Iajuddin Ahmed signed an order ending the emergency, a Home Ministry statement said.

The national election on Dec. 29 will end two years of rule by a military-backed interim authority that took over amidst violence and political turmoil in January 2007.

The lifting of the emergency, welcomed by foreign election monitors, will allow political parties to campaign freely.

Bangladesh's two main parties, the Awami League led by Sheikh Hasina and the Bangladesh Nationalist Party headed by Begum Khaleda Zia, had threatened to boycott the election if the emergency remained in force.

Investors and diplomats hope the vote will mark a move away from Bangladesh's history of street politics, sporadic bouts of military rule and endemic graft, which have held it back from tackling massive poverty and ending dependence on foreign aid.

U.S. Ambassador James F. Moriarty said the lifting of the emergency would set the stage for "free, fair and credible elections".

Although the interim government, headed by former central bank governor Fakhruddin Ahmed, had eased curbs on political gatherings gradually and pulled troops back to their barracks over the past few months, it had refused to withdraw the emergency fully until close to the vote to prevent violence.

The interim authority took over in January 2007 following months of unrest, along with crippling strikes by supporters of Hasina and Khaleda -- both former prime ministers -- which forced cancellation of an election planned for that month.

The two women have told election officials they want a peaceful transition to democracy.

The government said it would deploy troops across the country from Thursday to step up security in the run-up to the vote.

Fakhruddin met chiefs of the army, navy and airforce at military headquarters and asked them to help the Election Commission conduct a "fair, peaceful and credible vote".

SOLDIERS HAPPY

Army chief General Moeen U. Ahmed said soldiers were happy to return to their barracks.

"I hope the nation will evaluate our contributions in their right perspective," he said.

Army generals ruled Bangladesh for 15 years, in uniforms or civilian suits, until the end of 1990.

Hasina and Khaleda, who rotated in power for over 15 years to October 2006, were among hundreds of politicians arrested during the state of emergency for alleged corruption.

The two have been released after nearly a year in prison, following pressure on the government at home and abroad, to ensure their parties take part in the polls.

The European Union said it had deployed its election observation mission in Bangladesh "in the light of the re-instatement of the rights to assembly and freedom of expression which are essential for campaigning".

Bangladesh suffered a wave of attacks in 2005, blamed on hardline Islamist groups trying to impose sharia law in the secular nation. Security officials said such organisations were trying to regroup ahead of the election.

For a factbox on the emergency click [ID:nDHA401204]

For an analysis on the election click [ID:nDHA399949]

For a factbox on the main parties click [ID:nDHA7151]

(Additional reporting by Ruma Paul and Masud Karim; Editing by Dean Yates)

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