RAMALLAH, West Bank, May 8 (Reuters) - Prime Minister Salam Fayyad said on Tuesday the Palestinians may have "lost the argument" on the international stage for an independent state but cautioned that continued Israeli occupation was unsustainable.

In an interview with Reuters, Fayyad struck a note of discord with Palestinian President Mahmoud Abbas by calling for elections that have long been delayed because of deep political divisions between the Gaza Strip and the occupied West Bank.

He also warned his administration's future was clouded by severe financial strains and said the Palestinians had failed to galvanise a distracted world behind their cause.

"I think we are losing the argument, if we have not already lost the argument. But that doesn't make our position wrong," said the former World Bank economist, a political independent who has had strong support amongst Western powers.

Arab unrest, the U.S. presidential elections and financial crises in Europe had combined to knock the Palestinian issue off the global agenda more than 18 months after peace talks with Israel broke down in a dispute over Jewish settlement building.

"What is the biggest obstacle we face? The state of marginalisation. It is unprecedented," he said. "The Israelis have managed to successfully trivialise our side of the argument," he added, alluding to the Palestinian demands for a halt to settlement building before negotiations can resume.

Israel says talks should continue without preconditions and has continued to build housing in blocs that dot the West Bank on land the United Nations deems illegally occupied.

Speaking from his offices in Ramallah, 20 km (12 miles) from Jerusalem, with the red, black, green and white national flag behind him, Fayyad said Palestinians must get their own house in order before they could hope for long-cherished independence, which most world powers continue to support in principle.

"I do not believe we will be able to get a state unless we are able to reunify our country," he said of the political divide that has split the West Bank from the coastal enclave of Gaza, governed since 2007 by the Islamist group Hamas.

DEEP FREEZE

Attempts by Abbas, who rules in the West Bank, to bridge this divide over the past year have failed amid mutual recriminations and plans to hold long-awaited elections this month across the Palestinian territories were shelved.

"The reconciliation process is in the deep freeze. Let's face it," Fayyad said, adding that the Palestinians should forge ahead with election plans regardless of opposition from Hamas in order to re-engage with a disillusioned populace.

"A basic right of our people is being violated. The right of being able to chose our leadership," he said.

The last presidential and parliamentary elections were held in 2006 and many Palestinians, including Abbas and the Hamas leadership, have said a fresh vote can happen only if both the Gaza Strip and the West Bank are involved.

Strains have been reported in relations between Abbas and Fayyad since the prime minister refused to hand over a letter from the president to Israeli premier Benjamin Netanyahu laying out Palestinian grievances over the failure of talks.

Fayyad disagreed with the initiative last month but said the episode was now behind them and confirmed the two were working on the formation of a new government, where he will remain prime minister but will likely lose the finance portfolio.

Given the task of building institutions in readiness for statehood, Fayyad said his job was being imperilled by a lack of resources, with Arab nations failing to hand over promised aid.

"There is an issue of survivability of the Palestinian Authority given the acute financial crisis we are going through," he said, adding his government needed a "few hundred million dollars" to keep afloat.

The Palestinian Authority - which exercises limited self-rule in the West Bank - depends on donor aid from the United States, the European Union and Arab states to pay the salaries of public workers, including teachers and security personnel.

The Palestinians had planned for foreign aid of about $1.1 billion in 2011, but received just under $750 million and are lagging again in donations this year. No reason has been given for the failure of some Arab allies to honour their pledges.

Despite the many challenges facing the Palestinians and the lengthy breakdown in peace negotiations, Fayyad said he was convinced that independence would be achieved within 10 years.

"Occupation is not only a major political failure, but given its oppressive nature it is also a moral failure for Israel. It is not something that can be sustained," he said. "Walls have gone down elsewhere. Why should here be an exception?"