JERUSALEM, June 14 (Reuters) - Israel's cabinet approved on Monday an Israeli inquiry into a deadly raid on a Gaza aid flotilla, responding to international demands for impartiality by putting two foreign observers on the panel.

The decision coincided with growing signs Prime Minister Benjamin Netanyahu was poised, under international pressure, to ease controls on the flow of goods into Israeli-blockaded Gaza, home to 1.5 million Palestinians and run by Hamas Islamists.

Middle East envoy Tony Blair said he hoped Israel would begin softening the blockade within days.

Angered by the killing by Israeli commandos of nine Turkish pro-Palestinian activists on May 31, Turkey said Israel's investigation would be biased and reiterated demands for a UN-controlled probe. Hamas spoke of an Israeli cover-up.

Washington backed a UN Security Council statement that called for a prompt, impartial, credible and transparent investigation conforming to international standards.

Palestinian President Mahmoud Abbas, on a visit to Paris, said the Israeli panel does not correspond to what the Security Council asked for.

Netanyahu had consulted on the issue with the United States, which welcomed the Israeli inquiry. He did not appear to be in any political danger from a government-appointed inquiry, led by a former supreme court justice, with a narrow mandate.

I believe the cabinet's decision this morning to set up this independent public commission will make clear to the entire world that Israel acts lawfully, transparently and with full responsibility, Netanyahu told reporters.

Israel said its marines acted in self-defence in opening fire after a boarding party on the Turkish-flagged Mavi Marmara was attacked by activists wielding clubs and knives.

But the bloodshed during the raid, to stop a six-ship aid flotilla from breaking the blockade, raised an international outcry and pressure on Israel to lift an embargo that it says is necessary to limit arms smuggling to Hamas.

Netanyahu's cabinet voted unanimously to set up the commission headed by retired justice Jacob Turkel, the prime minister's office said.

EASING PRESSURE

It will include two other Israelis -- an international law expert and a former general -- and two non-voting foreign observers: David Trimble, a Northern Ireland politician and Nobel Peace Prize winner, and Canadian jurist Ken Watkin.

I can confirm that I have been approached and I am happy to do it, Trimble said in London in a telephone interview.

I am not going to discuss or make any public comment about the issues at stake because I have to come at the issues from an objective point of view.

The panel's mandate, as stipulated in a statement on Sunday, does not include an examination of the Netanyahu government's decision-making role in a raid that is regarded by many Israelis as a fiasco because of its planners' apparent failure to gauge the strength of resistance on board the Turkish ship.

Instead, it will examine whether the Gaza blockade and the flotilla's interception conformed with international law and also investigate the actions taken by the convoy's organisers and participants, the statement said.

Israeli commentators said the commission's limited mandate indicated that it was mainly designed to ease international pressure on the Netanyahu government.

The commission is designed to satisfy friendly countries, namely the United States and European Union states, former Israeli Justice Minister Daniel Friedmann told Israeli Channel 1 television.

The commission will publish a report, but it was not immediately clear when it would issue findings. It will have the power to decide which of its sessions to open to the public.

Israel's one-sided inquiry is not valuable to us. We want a commission to be set up under the direct control of (the) United Nations, Turkish Foreign Minister Ahmet Davutoglu told a news conference in Ankara.

In Luxembourg to brief EU foreign ministers on the humanitarian situation in the Gaza Strip, Blair spoke about possible Israeli moves to loosen the blockade.

In respect of the closure policy, I hope very much in the next days we will get the in-principle commitment that we require, but then also steps beginning to be taken, he said.

The International Committee of the Red Cross said the blockade violated the Geneva Conventions and should be lifted.

The United States has called the situation in the Gaza Strip unsustainable, and moves by Netanyahu to revise the embargo could help to ensure him a warmer White House welcome during a visit he hopes to make later this month.

Washington, caught in a balancing act between Israel and Turkey, two key US allies in the Middle East, voiced confidence that Israel would conduct a fair investigation.

Turkey has withdrawn its ambassador from Israel, cancelled joint military exercises and called for the blockade to end.

Netanyahu has said soldiers and officers who took part in or planned the operation would not testify before the commission. The panel would be able to use testimony given to a separate military board reviewing operational details of the raid.