BEIRUT, Lebanon - Lebanon marks the anniversary on Thursday of a blistering war between Israel and Hezbollah facing political paralysis, economic crisis and possibly the final battle in a deadly showdown with Islamist guerrillas.

"Quite simply, Lebanon has become a house divided," Lebanon's Daily Star newspaper lamented.

The war that cost more than 1,200 lives in Lebanon and 160 in Israel, broke out when guerrillas from the Shiite movement Hezbollah staged a raid into Israel, capturing two soldiers.

Israel retaliated with a ferocious air, sea and land assault on the country that left its infrastructure in tatters and destroyed thousands of homes.

On Wednesday, Prime Minister Fuad Siniora called on his countrymen to heal their deep political divisions and unite behind the army.

"Just as we stood together to confront the aggression... I take this opportunity to extend my hand again to all our brothers," Siniora said. "We have to return to dialogue and reconciliation."

Siniora said unity was essential to overcome tough challenges ahead, especially post-war reconstruction, the extension of state authority over the whole of Lebanon and implementation of long-awaited reforms.

The military is seen as a unifying factor, with such major institutions as the parliament and presidency paralysed amid an almost eight-month deadlock between the Siniora government and the Hezbollah-led opposition backed by Syria and Iran.

Lebanese remain jittery after a string of attacks targeting prominent anti-Syrian figures and there are fears the turmoil could worsen in the run-up to a September deadline for a presidential election.

The economic fallout from the 34-day war has also been enormous.

Tourists and foreign investors stayed away from Lebanon for a second straight year and the economy shrank five percent in 2006. Material damage in the war was an estimated 3.6 billion dollars, not counting lost revenues.

Much of the battered infrastructure has been restored, as billions of dollars in foreign aid flowed in, but the rebuilding of homes has been slow.

On the other side of the fence, Israel has also paid a heavy price.

It is still coping with the after-effects of a conflict that weakened the government and failed to achieve its main aims of freeing the captured soldiers and neutralising Hezbollah.

Prime Minister Ehud Olmert, accused of "severe failures" in an interim report by the so-called Winograd Commission, will probably face new calls for his resignation when the pane releases its full report in August.

Israel cites improvements along the border, with towns, businesses and homes targeted by an unprecedented barrage of more than 4,000 Hezbollah rockets almost entirely rebuilt.

But residents and officials say that while Hezbollah may be less visible, it remains ready for round two of what Israel calls the Second Lebanon War, in which 116 of its soldiers and 44 civilians were killed.

UN chief Ban Ki-moon has deplored the failure to reach a permanent ceasefire, release the captured soldiers and end Israeli violations of Lebanese airspace.

He has also called persistent reports of breaches of the arms embargo along the Lebanon-Syria border "a major impediment" to a long-term solution.

As Siniora deals with the aftermath of the war and a political crisis that dates back to the 2005 assassination of predecessor Rafiq Hariri, widely blamed on Syria, he is also challenged by an Islamist menace.

He called Wednesday for the army to put a "final end" to the Fatah al-Islam "criminal gang" fighting troops in northern Lebanon in what is the worst violence since the 15-year civil war which ended in 1990.

At least 174 people, including 86 soldiers and at least 68 Fatah al-Islam fighters, have been killed in the battles since May 20 around the besieged Palestinian refugee camp of Nahr al-Bared.

Hezbollah chief Hassan Nasrallah warned in May that the government's close ties with Washington would only serve to provoke and embolden Sunni Muslim extremists.

"By serving American strategic interests, you are transforming Lebanon into a chosen land for terrorists," he said.

As both Lebanon and Israel grapple with the war's consequences, human rights groups spoke of war crimes.

"Both sides in this conflict violated the laws of war, but a full year later, no one has been held accountable," Human Rights Watch's Middle East director Sarah Leah Whitson said.

HRW said the Winograd Commission was not mandated to probe violations by Israeli soldiers, while Lebanon's internal strife has sapped "both its will and, seemingly, the capacity to investigate" Hezbollah's actions.

Amnesty International also lamented a "complete absence of any steps in the two countries affected or internationally to prosecute those responsible for war crimes and other grave violations committed" during the war. -AFP