Israeli authorities tracking Hamas's funds said they made an unexpected discovery last month -- cash from one of Israel's biggest banks had found its way to a security force loyal to the Palestinian Islamists in Gaza.

Officials, speaking to Reuters this week on condition of anonymity, said the incident sparked a inquiry by the Justice Ministry's anti-money laundering authority and fuelled debate within the Israeli government and banking community over whether to cut financial links to Palestinian banks in the Gaza Strip.

That debate came to a head when Israel's largest commercial bank, Bank Hapoalim , said on Tuesday it would stop providing Israeli shekel notes and coins to Gaza. Hapoalim attributed the move to last week's declaration by Israel that Gaza, where Hamas seized control in June, is an "enemy entity".

Israeli regulators said banks including Hapoalim have been pushing for months to sever banking ties to Gaza, arguing there was little profit in it and no way to know whether their shekels could end up with Hamas, putting the banks in legal jeopardy.

Laws in Israel and the United States bar the transfer of funds to Hamas, which they deem a "terrorist" organisation.

Regulators say Discount Bank and other Israeli banks plan to follow Hapoalim's lead, threatening Gaza's money supply and President Mahmoud Abbas's ability to pay public sector wages -- part of a U.S.-led, Israeli-backed strategy to bolster his West Bank-based administration and weaken Hamas.

"This is a political issue," said a senior official with Israel's central bank, the Bank of Israel.

"Allowing coins and notes into Gaza is the same as water and medicine -- part of it can go to ... members of Hamas."

SHEKEL-DEPENDENCY

The shekels that cash-strapped Gazans depend on arrive about once per month by armoured convoy across Israel from the West Bank. At the Gaza border, the trucks unload the cash, back to back, into armoured trucks waiting on the Palestinian side.

The cash convoys continued after Hamas's violent takeover in June, despite concerns voiced by some Israeli banks and regulators and with a nod from Israeli Prime Minister Ehud Olmert's office and defence officials.

The anaemic Gaza economy depends on a steady supply of Israeli shekels to finance imports, pay Palestinian Authority workers and carry out day-to-day transactions.

Security inside Gaza had been handled by forces loyal to Abbas since Israel withdrew troops and settlers in 2005. Now, bank officials say, Hamas's Executive Force provides protection.

"Our responsibility is only inside Israel," said Shlomo Dror, spokesman for the Israeli coordinator for the Palestinian territories -- Gaza and the Israeli-occupied West Bank.

A senior Israeli government official said Israel "for the moment" will not allow additional cash shipments to Gaza.

But that could change if the government accepts a proposal by the Bank of Israel to use the state-owned Postal Bank to keep Gaza's financial institutions supplied with shekels.

INVESTIGATION

The investigation by Israel's anti-money laundering authority centres on how shekels from Discount Bank, Israel's third biggest, ended up in accounts held by the Hamas Executive Force at the Palestine Islamic Bank in the Gaza Strip when Abbas's government paid salaries in early August.

Israeli officials involved in the probe said Discount Bank had no way to know the shekels were being diverted despite Israeli efforts to block funds from reaching Hamas.

According to investigators, the Palestine Islamic Bank received the shekels from the Bank of Palestine, which in turn got them from Discount Bank under a long-standing arrangement.

Israeli authorities said they were not aware at the time that the Bank of Palestine was supplying the shekels to the Palestine Islamic Bank in Gaza.

Abbas's government in the West Bank, led by Prime Minister Salam Fayyad, thought the Executive Force had been purged from the payroll. Before the government discovered the payments, some 3 million shekels ($745,000) had been deposited in Executive Force accounts, Western diplomats and bank officials estimate.

A Palestine Islamic Bank official confirmed that its Gaza branches get their shekels from the Bank of Palestine. Bank of Palestine officials had no immediate comment.

"The (Israeli) anti-money laundering authority does not disclose details of investigations it is conducting," the Justice Ministry said in a statement to Reuters.

A Discount Bank spokeswoman said it did not have control over the money once it was transferred to the Bank of Palestine.

"Unbeknownst to Discount Bank, it was clearing money for the Executive Force," said a senior Israeli official.

For Israeli commercial banks worried about their public image and possible lawsuits, the official added, the move to sever financial ties to Gaza is "a relief". (Additional reporting by Mohammed Assadi in Ramallah and Nidal al-Mughrabi in Gaza)