By John O'Donnell

BRUSSELS (Reuters) - The European Union moved a step closer to imposing financial sanctions on Croatia on Wednesday, frustrated that Zagreb has failed to make its extradition laws comply with EU legislation.

The European Commission said Croatia, the EU's newest member state, had two weeks to amend its laws or face the suspension of financial aid, which will stall efforts to improve border controls and harm its bid to join Europe's passport-free zone.

Viviane Reding, the European commissioner in charge of justice issues, has accused Zagreb of "misusing the trust" placed in it by the EU and said it must fall into line.

The dispute focuses on a law the Croatian parliament amended just three days before the country joined the EU on July 1 this year. The amendment means anyone accused or convicted of a crime before August 2002 cannot be transferred abroad.

As a result, those accused of atrocities during the Balkans wars of the 1990s cannot be extradited to face trial, contradicting the EU's arrest warrant legislation.

"The Commission has consistently requested a swift and unconditional correction of the Croatian legislation implementing the European arrest warrant," the Commission said in a statement on Wednesday.

Pointing out that it took Croatia just a matter of days to change the law, the Commission said "returning it back to conformity should not take longer".

Croatia's Social Democratic prime minister, Zoran Milanovic, told parliament on Wednesday the law would be changed but would only take effect next July after legislators approved changes to the constitution to allow for the prosecution of politically motivated murders regardless of when they were committed.

"We shall change the law and ask for a delay in its implementation, but no one should doubt that all suspects will eventually have to face justice," he said.

Wednesday's move by the Commission gives EU member states two weeks to consult on the sanctions before imposing measures. Since the consultation is a formality, the only way sanctions can be stopped is if Croatia changes the law.

It is not uncommon for the Commission to take steps against a member state for non-compliance with legislation, but never has a move towards sanctions been made so quickly after a country has joined the bloc.

Croatia's opposition HDZ party, which ruled the country in the 1990s and between 2004-2011, has accused Zagreb's leftist-led government of tweaking the law to protect former Croatian intelligence chief Josip Perkovic.

Perkovic worked for communist Yugoslavia's secret service, the UDBA, and led intelligence services after Croatia became independent. He now faces charges in Germany over the 1983 murder of a Yugoslav dissident in Bavaria.

Milanovic says there is no connection.

(Reporting By John O'Donnell; Additional reporting by Igor Ilic in Zagreb; editing by Elizabeth Piper)

 

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