The European Union agreed on Monday to suspend most of its sanctions against Myanmar for a year despite a dispute over a parliamentary oath between the army-backed ruling party and pro-democracy leader Aung San Suu Kyi.

In the first clear sign of friction since Suu Kyi's party swept historic by-elections, the ruling party on Monday rejected her demand to replace the words safeguard the constitution with respect the constitution in the oath.

Suu Kyi and party colleagues refused to take their seats at the opening of parliament, denting the image of political transformation Myanmar hopes to portray.

Despite this, EU foreign ministers decided to suspend sanctions in recognition of democratic reforms after half a century of military rule.

I don't think that's a reason for us to do anything different that what we're doing, EU foreign policy chief Catherine Ashton said of the dispute over the oath. But of course we want to see a resolution to that so that in fact they can take their seats.

One EU diplomat said the sanctions suspension did not mean Myanmar was a fully democratic country, and that it was up to the people there to work out problems like the oath.

The suspension, which does not apply to a separate arms embargo, is likely to go into effect this week. It will allow European companies to invest in Myanmar, which has significant natural resources and borders economic giants China and India.

The EU had frozen the assets of nearly a thousand companies and institutions, and banned almost 500 people from entering the EU. It also prohibited military-related technical help and banned investment in the mining, timber and precious metals sectors.

The EU is rewarding a shift that has seen many political prisoners freed and a range of repressive measures lifted.

NOT YET IRREVERSIBLE

President Thein Sein has taken important steps towards reform in Burma, and it is right for the world to respond to them, British Prime Minister David Cameron said in a statement.

But those changes are not yet irreversible, which is why it is right to suspend rather than lift sanctions for good.

British Foreign Secretary William Hague said the suspension of sanctions should lure back some investment.

Clearly the suspension, and the prospect of ending them (sanctions) at a later stage altogether, means that businesses will be looking in that direction. But it is a suspension. These sanctions could be reimposed as the path of reform changes, he told reporters.

In a statement released by foreign ministers meeting in Luxembourg, the EU urged Myanmar to free remaining political prisoners and remove restrictions on those already released.

Of course reforms in that country need to continue, Ashton said. I understand that we have about 700 prisoners who have been released and somewhere between 200 and 600 still there.

The EU has already offered 150 million euros (124 million pounds) in development aid for this year and next, a sharp rise from the less than 200 million euros it has given since sanctions were launched in 1996.

The ministers said they aimed to include Myanmar in the EU's preferential trade scheme for less developed countries if the International Labour Organisation approves its labour standards.

LINGERING QUESTION

European companies are vying with Asian rivals for stakes in a range of industries, from oil and gas to timber, tourism, telecommunications and banking, many of them underdeveloped during years of economic isolation.

Cameron this month became the first British prime minister to visit since Myanmar won independence from Britain in 1948, and took several business executives with him. EU foreign policy chief Catherine Ashton plans to travel to Myanmar on Saturday.

The United States is also moving to ease bans on U.S. companies investing in and providing financial services to Myanmar, and says it will first target sectors that could support democratic reforms.

It has already permitted non-governmental organisations to support certain humanitarian, religious and educational activities in Myanmar.

But some would like the restrictions lifted faster.

The suspension somehow leaves a lingering question: Is this really the signal to 'Go'? said Jonas Parello-Plesner at the European Council on Foreign Relations in think-tank London.

If you're a company, would you invest in a country where the sanctions could come back in place? he said. There's a very high risk.

($1 = 0.7571 euros)

(Reporting by Justyna Pawlak and Sebastian Moffett; Editing by Robin Pomeroy)