JERUSALEM, May 24 (Reuters) - The European Union could rethink the future size of its 300 million euro ($370 million) aid budget for Palestinians if no progress is made towards peace soon, EU diplomats said on Monday.

The aid is supposed to prepare the Palestinians for a peace treaty with Israel that will give them their own state, but if that isn't coming then I can see a number of questions, said Christian Berger, the EU's representative in Jerusalem.

The annual assistance given to the Palestinians over the past 16 years represents the EU's highest per capita foreign aid programme. The current seven-year budget, part of which funds United Nations support projects, is locked in until 2013.

A delegation from the European Parliament is visiting Israel and the Palestinian territories this week and would certainly be asking if at the end of the day we don't have a state, then what are we doing with the money, Berger added.

EU Ambassador to Israel Andrew Standley said discussions on the next seven-year budget would start soon and focus on how best to spend the money.

There was a debate about whether it should be spent mostly on reducing poverty or more should be devoted to projects that advanced EU geopolitical goals, he said.

After 16 months without negotiations of any kind, Israel and the Palestinians began indirect talks this month on a peace treaty via United States mediator George Mitchell.

If there's a breakthrough then I guess there's a likelihood that our support will be increased, Berger told reporters at a briefing of EU delegation heads.

A two-year plan by Western-backed Palestinian Prime Minister Salam Fayyad to build the institutions of a state was well on track, Berger said. The Palestinian Authority was performing better than some states which are states already.

About 71 million euros of the total 2010 aid package is going to support the Fayyad plan, which is supposed to be complete by August 2011. The visiting EU parliamentarians know Fayyad will be seeking more money later this year to cover a shortfall.

Israel is concerned that if peace talks do not result in a treaty to resolve the 62-year-old conflict, the Palestinian leadership might declare statehood unilaterally, with the hope of support from the 27-member EU.

The EU diplomats said they believed seven European countries that are now EU members had already recognised a Palestinian state before they joined the EU and currently hosted Palestinian embassies in their capitals.