* Trade settlement mechanism between India, Iran breaks down
* Fears of U.S. sanctions mean banks still largely shun Tehran
* Funds in Iran's India account depleted to just $305 million
* India, Iran seek European bank to settle trade in euros
By Nidhi Verma and Manoj Kumar
NEW DELHI, March 22 (Reuters) - India is exploring setting up a new payments mechanism for trade with Iran, after its old sanctions workaround broke down, as state banks remain fearful of handling payments from Tehran in case the United States imposes a fresh financial embargo.
U.S. President Donald Trump has denounced an agreement between Iran and major powers on its nuclear programme as a bad deal, and his administration has put Tehran "on notice" after the test-firing of a ballistic missile.
Under previous Western sanctions, India had devised a barter-like scheme acceptable to Washington that allowed it to make some oil payments to Tehran in rupees through a small state bank, UCO Bank.
Indian companies were then able to receive payments for goods exported to Iran using the oil money held in non-convertible rupee balances at UCO, maintaining a trade lifeline between two countries with long historical ties.
But since sanctions were partly lifted early last year the rupee account has been run down by more than 90 percent to just 20 billion rupees ($305 million) because Indian refiners have resumed paying for Iranian oil in euros.
Whilst the federal government and central bank have approved oil payments in euros - which Iran prefers because the currency is readily convertible - they have not given the all-clear for trade in the opposite direction to be settled in other currencies, leaving exporters stuck.
"We are working on a mechanism through euros and looking for a common correspondent bank in Europe to act as an intermediary for India and Iran," said R.K. Takkar, chairman of UCO Bank.
"The euro payment system has not yet crystallised," he said, adding the government was working to find a solution.
The Reserve Bank of India (RBI) said some Iranian banks had applied to open branches in India, but gave no indication when it might approve settlement of trade with Iran in currencies other than the rupee.
"Due to the geopolitical situation around Iran, and international sanctions-related measures, correspondent banking relationships are difficult," the central bank said in a written reply to questions submitted by Reuters.
"The Reserve Bank has facilitated payment for Indian exporters by permitting special arrangements for rupee-based settlements."
Although European Union and United Nations sanctions against Iran have been removed some U.S. measures remain, and that, along with the hard line promised by the new administration in Washington, has left the country still largely shut out of the global financial system as banks steer clear of its business.
As tensions grow, New Delhi and Tehran are considering reverting to the old rupee mechanism that was viewed as a safe bet because UCO has no U.S. exposure that could lead it to fall foul of any new sanctions.
Iran has agreed in principle to accept some oil payments in rupees to fund imports from India worth an estimated $2.5 billion a year, a senior commerce ministry official told Reuters.
No timeline has been fixed as yet to implement the new mechanism, however, as both sides await the outcome of Iran's presidential election in May and seek clarity on the Trump administration's approach towards Tehran, he said.
The payment woes have hit the revenues of Indian exporters as they struggle to complete deals struck when the rupee account was flush with funds. Several containers from India are held up at Iranian ports, exporters said.
"Our clients are threatening to cancel orders and procure from China," said Jayanti Goela at Gas Lab Asia, a Delhi-based exporter that had won an order to supply gas storage tanks to Tehran.
India's major exports to Iran include food, chemicals, engineering products, garments and drugs.
The reticence of Indian banks with U.S. exposure has also slowed work on the Iranian port of Chabahar and a $1.6 billion rail link backed by New Delhi that would bypass arch-rival Pakistan and counter China's growing influence in the region.
One official involved in the Chabahar project said contractors, concerned about getting paid, were now reluctant to supply equipment and materials for the Arabian Sea port whose completion is planned for 2018.
"If Trump imposes more sanctions on Iran, we may have to wind up most of our plans," the official said.
Foreign minister Sushma Swaraj told parliament recently that Iran had yet to ratify a trilateral pact to set up the transit corridor to Afghanistan that was signed on a visit last year by Prime Minister Narendra Modi.
"The government is still in a wait-and-watch mode and closely monitoring Trump's approach towards Iran," said a senior official who joined Modi on his trip to Iran.
India, Iran's top oil client after China, boosted exports to Tehran during sanctions as Western nations boycotted it.
Yet India has lost out since the lifting of sanctions, with its exports to Iran declining to $2.4 billion in 2016 from $3.2 billion in the previous year. ($1 = 65.6400 Indian rupees)
Reporting by Manoj Kumar and Nidhi Verma; Editing by Alex Richardson