By Reza Derakhshi and Fredrik Dahl
TEHRAN (Reuters) - Iran's president gave instructions on Sunday for the production of higher-grade nuclear reactor fuel despite an offer by world powers to provide it to the Islamic Republic to allay fears Tehran is making an atomic bomb.
President Mahmoud Ahmadinejad's announcement prompted U.S. Defence Secretary Robert Gates to call Iran's response "very disappointing." Gates has suggested it is time for more sanctions against Tehran.
Ahmadinejad, who says his country's nuclear programme is to make electricity and not bombs, told Iran's Atomic Energy Organisation to start work on producing higher-grade reactor fuel for a medical research reactor.
The United States and other big powers have proposed that Iran send most of its low-enriched uranium abroad in return for nuclear fuel refined to a level of 20 percent, for use in the Tehran reactor producing medical isotopes.
But Ahmadinejad's declaration that Iran will make its own nuclear fuel rather than accepting it from abroad under the nuclear swap plan raises the stakes in the dispute.
"We had told them (the West) to come and have a swap, although we could produce the 20 percent enriched fuel ourselves," Ahmadinejad said in a televised speech at a ceremony marking Iran's latest laser technology achievements.
"We gave them two-to-three months' time for such a deal. They started a new game and now I (ask) Dr Salehi to start work on the production of 20 percent fuel using centrifuges," he said, referring to atomic energy chief Ali Akbar Salehi who attended the event.
But Salehi said his organisation was only put on standby.
"The president ordered the Atomic Energy Organisation to be on standby, so that if the talks on nuclear fuel exchange does not reach an agreement, then the organisation starts production, because this needs some preparations," he told the official IRNA news agency.
State broadcaster IRIB quoted Ahmadinejad as saying that if world powers agreed to swap uranium without conditions, "then we would cooperate as well. We are ready for negotiations."
Iran enriches uranium to a level of about 3.5 percent. Refined uranium can have both civilian and military uses -- the latter requiring much higher levels of enrichment.
"If the international community will stand together and bring pressure to bear on the Iranian government, I believe there is still time for sanctions and pressure to work. But we must all work together," Gates told a news conference in Rome.
"Pressures that are focussed on the government of Iran, as opposed to the people of Iran, potentially have greater opportunity to achieve the objective," he said.
The five permanent U.N. Security Council members -- United States, China, Russia, Britain and France -- plus Germany met on Friday to discuss the Iran nuclear issue, but China made clear it was too soon to discuss further sanctions.
Gary Smith, executive director of the American Academy think-tank in Berlin, said Ahmadinejad's statement was not a surprise. "It increases the likelihood of stronger sanctions but the Chinese are still the big question mark," he said.
Ahmadinejad also said Iran had the capability to enrich uranium using laser technology, but the official IRNA news agency said the country was not planning to do this as it already had enrichment centrifuges.
On Tuesday, the president had appeared for the first time to drop long-standing conditions Tehran had set for accepting the U.N.-brokered fuel proposal, saying Iran was ready to send its enriched uranium abroad in exchange for nuclear fuel.
But the United States and Germany said on Saturday they saw no sign Tehran would make concessions on its nuclear programme, despite upbeat comments from Iran's Foreign Minister Manouchehr Mottaki over prospects for a deal.
Three sets of U.N. sanctions have already been imposed against for its failure to halt enrichment.
Some analysts interpret the mixed messages from Tehran as a sign of splits linked to political turmoil after Iran's disputed June presidential election. Others see it as a delaying tactic.
Mottaki said on Friday he saw good prospects for agreement, but restated two conditions that could be stumbling blocks -- that any fuel exchange must be simultaneous and that Iran would determine quantities involved.
He said on Saturday he had "a very good meeting" with the head of the U.N. nuclear agency on the fuel swap plan.
International Atomic Energy Agency (IAEA) Director-General Yukiya Amano said he wanted dialogue with Iran to speed up.
(Additional reporting by William Maclean; Adam Entous in Rome; Editing by Charles Dick)