(Reuters) - Iran is installing more centrifuges in an underground plant but does not yet appear to be using them to expand higher-grade uranium enrichment that could take it closer to producing atom bomb material, Western diplomats say.

They say Iran´s production of uranium refined to a fissile concentration of 20 percent, which it started two years ago, seems to have remained steady in recent months after a major escalation of the work in late 2011 and early this year.

Progress in Iran´s controversial nuclear program is closely watched by the West and Israel as it could determine the time the Islamic Republic would need to build nuclear bombs, should it decide to do so.

Getting Iran to stop the higher-level enrichment is expected to be a priority for world powers when they meet with Iran in Baghdad next week in an attempt to start resolving the decade-old dispute over Tehran´s atomic ambitions.

"It is still going strong. I hear it is unchanged," one diplomat accredited to the U.N. nuclear watchdog, which regularly inspects Iran´s declared atomic sites, said about the country´s most sensitive nuclear activity.

"But with installation work going on, at some point there will be an increase."

Tehran took a big step towards the capability of making nuclear weapons material after a previous attempt at diplomacy failed when, spurning U.N. demands to halt all enrichment, it instead ramped up uranium processing to 20 percent purity.

That provoked the West to impose crushing sanctions on its banks and oil exports.

A U.N. nuclear report published in February showed Iran trebling output of 20 percent uranium since late 2011 after starting up production at the Fordow underground plant near the Shi´ite Muslim holy city of Qom and later increasing it.

Another envoy said he did not expect to see a "significant expansion" of this work in the next quarterly report by the International Atomic Energy Agency (IAEA) on Iran´s nuclear program due later this month.

But installation of machines has continued, the diplomat said, referring to the centrifuges which spin at supersonic speed to increase the fissile isotope in uranium. Typically a set of 174 centrifuges is needed for one production unit.

A third Vienna-based diplomat painted a similar picture.

Nuclear bombs require uranium enriched to 90 percent, but much of the effort required to get there is already achieved once it reaches 20 percent concentration, shortening the time needed for any nuclear weapons "break-out".

Israel - widely believed to hold the Middle East´s only nuclear arsenal - and the United States have not ruled out military action to prevent Iran from obtaining atomic arms if negotiations fail to achieve this goal.

IRAN FLEXIBLE?

Iran has steadily increased uranium enrichment since 2007 and now has enough of the 3.5 and 20 percent material for some four bombs if refined further, experts say. The lower-grade uranium is the normal level required for nuclear power plants.

Tehran denies Western accusations of a nuclear weapons agenda and says it has a sovereign right to peaceful nuclear technology, repeatedly rejecting U.N. resolutions calling for a suspension of all uranium enrichment.

But it has at times appeared more flexible when it comes to the refinement to a fissile concentration of 20 percent, which it says it needs to fuel a medical research reactor in Tehran.

Experts say that initially getting Iran to stop this work could open a way to ease the deadlock.

British Foreign Secretary William Hague said Iran should take steps to "build confidence" in its nuclear activities.

"In particular Iran should take early action to address the concern about its production of 20 percent enriched uranium," Hague told parliament this week.

Britain, the United States, France, Russia, China and Germany are the six powers involved in diplomacy aimed at resolving the long-running row over Iran´s atomic plans, which has stoked fears of a new Middle East war.

Many analysts believe it may be unrealistic to demand that Iran suspend all enrichment as its leaders have invested so much national and personal prestige in the project.

In return for allowing limited, low-level enrichment, those analysts argue, Iran would need to accept much more intrusive U.N. inspections to make sure there is no military diversion of its nuclear program.

(Editing by Mark Heinrich) (© Thomson Reuters 2012. 05/16/12)