JERUSALEM (Reuters) - The day Israel captured Arab East Jerusalem in the 1967 Middle East war is burned deep in the memory of Libyan-born Jew Raphael Luzon.

His uncle, aunt and six cousins were killed on the edge of the capital Tripoli by Libyan soldiers out for vengeance. Luzon fled Libya soon after.

With Libya emerging from diplomatic isolation and holding out the possibility of compensation to Jews who fled abroad, Luzon hopes that he might be able to get back the remains of his family.

"I am not seeking revenge, only justice. I want to have the opportunity to take their bones and give them a proper Jewish burial," says Luzon, who led a campaign for compensation long before Libya´s Muammar Gaddafi suggested it.

Jews also see Gaddafi´s talk of reparations as a possible test case for other Arab countries, whose centuries-old Jewish populations left or were forced out after the founding of Israel in 1948.

The history of Libya´s Jewish community, once 40,000 strong, stretches back 2,500 years. Jews lived comfortably for centuries, their numbers boosted by expulsions from Spain and Portugal in the 15th century.

But pogroms were triggered by the war of Israel´s creation with Arab neighbors, when hundreds of thousands of Palestinian Arabs also fled or were driven from homes in what became the Jewish state.

Laws stripped Libyan Jews of rights and property and only 300 remained by the time Gaddafi seized power in 1969. He confiscated remaining Jewish assets and canceled all debts to Jews.

Most of the community now lives in Israel and few expected to have contact again with the country of their birth.

JEWS PUT TOTAL LOSSES AT $600 MILLION

But that has changed since Gaddafi ended Libya´s diplomatic isolation in 2003, announcing that it would give up the search for weapons of mass destruction and agreeing to pay victims of the 1988 Lockerbie airliner bombing.

At the same time, Gaddafi became the first Arab leader to say he could compensate Jews who were forced from their homes after 1948.

Libyan Jewish groups estimate the value of private assets lost at around $500 million with a further $100 million for public assets such as synagogues and cemeteries.

A small delegation of Jews living in Rome met Libyan officials in Tripoli last year as part of the emerging dialogue.

"I believe regarding Libya there will be positive developments in the coming year," says Moshe Kahlon, the deputy speaker of Israel´s parliament whose family is from Libya and who recently met Libyan representatives in London.

"(Compensation) will start with Libyan Jews in Italy and should develop in the direction of Israel," said Kahlon.

Libyan officials declined further comment on the compensation issue.

Jewish groups hope that if they get compensation from Libya then it may be possible to take the idea further in the Arab world, from where an estimated 850,000 Jews emigrated or were driven out, many settling in Israel.

There is no suggestion yet, though, that the Arab world might pick up on the ideas of the maverick Gaddafi.

Claims are also complicated by the fact that the departure of Jews from Arab states happened alongside the flight of hundreds of thousands of Palestinians.

PALESTINIAN REFUGEES

Millions of Palestinians who fled themselves or are descended from those who demanded a "right of return" to land in what is now Israel or at least compensation for their losses. Most live in Arab states neighboring Israel.

"Paying compensation to the Jews of the Arab world can only be seen by Palestinian refugees as a sell-out and an unjust formula while their rights are being simultaneously denied," says Abbas Shiblak, a British-based Palestinian writer on refugee issues and author of a book on the Jews of Iraq.

Some Jewish groups have called for Jews who fled Arab countries to be recognized as refugees in the same way that Palestinians have been. They also propose tying any compensation for Palestinians with that for Jews.

Palestinians argue that they are not responsible for the suffering of the Jewish communities.

The refugee issue remains one of the trickiest issues for any final Middle East peace talks, which still look a long way off despite an Israeli-Palestinian cease-fire which has strengthened hopes for negotiations.

Gaddafi´s son Seif al-Islam, a driving force behind the policy shift, emphasized recently that Libyan Jews who moved to Israel would need to prove that they had not taken Palestinian assets if they were to get compensation.

"They have to return the homes and properties they confiscated from Palestinians to the Palestinians before negotiations over getting back their assets and properties in Libya," he said. (Additional reporting by Lamine Ghanmi in Tunis) (© Reuters 2005. 05/10/05)