¦ China says ties with Japan badly damaged over boat row–¦ Japan says both sides should avoid fuelling nationalism

By Chisa Fujioka and Chris Buckley

TOKYO/BEIJING (Reuters) — China snubbed Japanese Prime Minister Naoto Kan, saying a territorial dispute ruled out any meeting with Premier Wen Jiabao in New York this week and adding to the ire dividing Asia's top two economies.

China's confirmation that Wen will not meet Kan when they both attend a UN meeting marked another swipe at Tokyo after a Japanese court extended the detention of a Chinese skipper whose boat collided with two Japanese coastguard ships earlier this month near islands in the East China Sea claimed by both sides. China has repeatedly demanded the captain's release.

China has protested over the incident and demanded the return of the ship's captain, who is being held by Japan and could face prosecution for obstructing the coast guards' public duties.

The boat was seized after it ignored demands to leave the area and collided with two Japanese patrol boats.

Japanese authorities have accused the Chinese captain of ramming a patrol ship and obstructing officers near the disputed, uninhabited islets in the East China Sea.

The Foreign Ministry stepped up the warnings and added the public snub of Japanese Prime Minister Kan, a step suggesting that it will take a while for diplomatic goodwill to return between the two neighbours, even after the boat case has passed.

"This issue has already seriously damaged China-Japan relations. The key to avoiding a further deterioration in the situation lies in Japan immediately and unconditionally releasing the man," Foreign Ministry spokeswoman Jiang Yu told a regular news briefing in Beijing.

It would not be right, Jiang said, for Wen Jiabao to meet Kan in New York during a United Nations development summit.

"Given the current atmosphere, arranging a meeting clearly would be inappropriate," she said.

The case of the boat captain has become a distillation of the distrust that threads through Sino-Japan relations, drawing in territorial disputes, Chinese bitterness over wartime occupation, Tokyo's anxieties about Chinese regional sway, and Japanese unease as China rises in global GDP rankings.

Many experts say neither country wants to risk their increasing trade flows through outright confrontation.

But some said the boat case has reopened nettlesome disputes put on hold as the two governments sought to end years of quarrels.

Saturday marked the anniversary of the 1931 "Mukden Incident" that led to the Japanese occupation of China's northeast. The date has in the past been marked by official commemorations and scattered anti-Japanese protests in China.

In Chinese-administered Hong Kong, ten people marched from a nearby post office to the downtown building housing the Japanese consulate demanding the release of the ship's captain.

The protesters chanted "Down with Japanese militarism" and "Japan Get out of Diaoyutai!" They left peacefully after delivering a list of their demands to a representative from the consulate.

While China's ruling Communist Party partly encourages anti-Japanese sentiment to burnish its nationalist credentials, it remains obsessed with social stability and suspicious of any independent movement that could spin out of control and challenge its authority. Websites of Chinese nationalist groups were blocked Friday as the government tried to forestall anti-Japanese protests ahead of a sensitive political anniversary.

In the background of the dispute is an ongoing question of access to natural gasfields in the East China Sea some 190 miles northeast of the islands, known as Senkaku by Japan and Diaoyu or Diaoyutai in Chinese.

Access to gasfields so close to their shores would be a boon for energy-hungry China as well as resource-poor Japan. A thorny issue for some time, the two sides agreed in 2008 to jointly develop the deposits.

Under that deal, Japanese will be allowed to invest and share in the profits of existing Chinese operations in the Chunxiao fields, which Japan calls Shirakaba, that run closer to China, while Japanese and Chinese will jointly develop other fields farther out.

The agreement marked a real breakthrough in Japan-China relations, which had struggled to improve for years.

While it could have easily bogged down in territorial disputes, the decision to shelve such claims in favour of progress is something almost unprecedented for the sides, particularly China which traditionally takes a hardline on all issues relating to sovereignty.

"The gasfields question has always been part and parcel of the Sino-Japanse relationship," said Sheila Smith, a senior fellow at the Council on Foreign Relations in Washington.

But if this territorial dispute "goes on the rocks, it could derail their ability to negotiate a common approach on the gasfield reserves," she said.

Since the collision incident, Japan has spotted Chinese ships bringing equipment to one of the gasfields, raising concerns that Beijing may start drilling unilaterally.

Responding to Tokyo's inquiry about the move, China said it had brought in equipment for "repairs" of a platform out at sea.

Jiang, the Foreign Ministry spokeswoman, said Tuesday that China possesses sovereign rights over the Chunxiao fields and that its activities there were "lawful and reasonable".

But she did not directly link the issue to the islands dispute, which she again blamed on Japan, and did not indicate any change in China's attitude toward development of the fields.

But trade ties remain robust.

China has been Japan's biggest trading partner since 2009 and bilateral trade reached 12.6 trillion yen ($147 billion) in the January-June period, a jump of 34.5 percent over the same time last year, according to Japanese statistics.