Iran increases underground nuclear capacity sharply-diplomats

* Fordow site is buried deep underground for protection

* Israel sees Iran's nuclear ambitions as existential threat

* Iran denies nuclear weapons aims, says programme peaceful

VIENNA, Aug 30 (Reuters) - A U.N. watchdog report is expected to show that Iran has expanded its potential capacity to refine uranium in an underground site by at least 30 percent since May, diplomats say, adding to Western worries over Tehran's nuclear aims.

The U.N. International Atomic Energy Agency (IAEA) is due this week to issue its latest quarterly report on Iran's disputed nuclear programme, which the West and Israel suspect is aimed at developing bombs. Tehran denies this.

Language used by some Israeli politicians has fanned speculation that Israel might hit Iran's nuclear sites before the November U.S. presidential vote. Washington has said there is still time for diplomatic pressure to work, but it could be drawn into any war between the two Middle East foes.

The Vienna-based diplomats, giving details on what they believe the IAEA report will show, said Iran had completed installation of two more cascades - interlinked networks of 174 centrifuges each - since the previous IAEA report in May.

They said Iran may also have added centrifuges in another part of the fortified Fordow facility, buried deep inside a mountain to better protect it against any enemy strikes, but they gave no details.

Fordow, where Iran is refining uranium to a level that takes it significantly closer to weapons-grade material, is built to house roughly 3,000 centrifuges - machines that spin at supersonic speed to increase the fissile concentration.

The May report said Iran had installed a total of 1,064 centrifuges, of which 696 were operating, in some six cascades. The diplomats said Iran has since added at least another 328, a jump of about 30 percent from the May figure, and perhaps more.

Iran says it needs this higher-grade uranium for a medical research reactor in Tehran. It is enriching uranium to lower levels at its main such plant in Natanz, where diplomats say it is also installing more centrifuges.

While the newly added centrifuges at Fordow are not yet operating, the expansion reaffirmed Iranian defiance of international demands to suspend enrichment, which can have both civilian and military uses depending on refinement level.

"There is reason to be concerned by increased tempo of enrichment, the larger stockpile of enriched uranium and, most importantly, the additional centrifuges installed in the deeply-buried facility at Fordow," said Mark Fitzpatrick of the International Institute of Strategic Studies think-tank.

It may reinforce the belief in Israel that diplomatic and economic pressure is failing to make the Islamic Republic curb its uranium enrichment programme.

Iran denies allegations it seeks a nuclear weapons capability and says all its atom work is for peaceful purposes. It has threatened wide-ranging reprisals if attacked.

Iran's supreme leader, Ayatollah Ali Khamenei, on Thursday told heads of state from developing countries at a meting in Tehran that the country has no interest in nuclear weapons but will keep pursuing peaceful nuclear energy.