By Ahmed Rasheed and Isabel Coles

President Barack Obama refused to rule out U.S. action in Iraq against Sunni Islamist militants who have surged out of the north to threaten Baghdad, threatening to divide the country and establish their own jihadist state.

Hours after ethnic Kurdish forces took advantage of the chaos to take control of the oil hub of Kirkuk as the forces of the Shi'ite-led government abandoned their posts, Obama was asked if he might order drone strikes or other action to halt the insurgency that has seized much of northern Iraq this week.

"I don't rule anything out," he told reporters, saying he was looking at all options to help the elected leaders who took full control of Iraq when the U.S. occupation ended in 2011.

He added that the United States had an interest in denying a foothold to the Islamic State in Iraq and the Levant (ISIL) and that Washington was prepared to take military action when its national security interests are threatened.

Vice President Joe Biden spoke to Prime Minister Nuri al-Maliki by telephone. The White House signalled on Wednesday that it was looking to strengthen Iraqi forces rather than meet what one U.S. official said were past Iraqi requests for air strikes.

With voters wary of renewing costly military entanglements of the past decade, Obama already last year stepped back from launching air strikes in Syria, where ISIL is also active. Fears of violence spreading may increase pressure for international action, however. The French foreign minister, Laurent Fabius, said international powers "must deal with the situation".

In Mosul, Sunni militants of the Islamic State of Iraq and the Levant staged a parade of American Humvee patrol cars seized from a collapsing Iraqi army in the two days since ISIL fighters drove out of the desert and overran the northern metropolis.

They now threaten Maliki's government, which has had substantial U.S. military aid but which has responded only patchily to Western urging to embrace an angry Sunni minority that views Maliki as too close an ally of Shi'ite Iran.

At Baiji, near Kirkuk, insurgents surrounded Iraq's largest refinery underscoring the potential threat to the oil industry, and residents near the Syrian border saw them bulldozing tracks through frontier sand berms - giving physical form to the dream of reviving a Muslim caliphate straddling both modern states.

AIR POWER

At Mosul, which had a population close to two million before recent events forced hundreds of thousands to flee, witnesses saw ISIL fly two helicopters over the parade, apparently the first time the militant group has obtained aircraft in years of waging insurgency on both sides of the Iraqi-Syrian frontier.

It was unclear who the pilots were, but Sunnis who served in the forces of Saddam Hussein, the Sunni dictator overthrown by the U.S. invasion of 2003, have rallied to the insurgency.

State television showed what it said was aerial footage of Iraqi aircraft firing missiles at insurgent targets in Mosul. The targets could be seen exploding in black clouds.

Further south, the fighters extended their lightning advance to towns only about an hour's drive from the capital, where Shi'ite militia are mobilising for a potential replay of the ethnic and sectarian bloodbath of 2006-2007.

Trucks carrying Shi'ite volunteers in uniform rumbled towards the front lines to defend Baghdad.

The stunning advance of ISIL, which aims to build a state ruled on medieval Sunni Islamic principles across Syria and Iraq, is the biggest threat to Iraq since U.S. troops withdrew.

Hundreds of thousands of people have fled their homes in fear as the militants seized the main cities of the Tigris valley north of Baghdad in a matter of days. The security forces of Iraq's autonomous Kurdish north, known as the peshmerga, or "those who confront death", took over bases in Kirkuk vacated by the army, a spokesman said.

"The whole of Kirkuk has fallen into the hands of peshmerga," said peshmerga spokesman Jabbar Yawar. "No Iraqi army remains in Kirkuk now."

Kurds have long dreamed of taking Kirkuk and its huge oil reserves. They regard the city, just outside their autonomous region, as their historic capital, and peshmerga units were already present in an uneasy balance with government forces.

The swift move by their highly organised security forces to seize full control demonstrates how this week's sudden advance by ISIL has redrawn Iraq's map - and potentially that of the entire Middle East, where national borders were set nearly a century ago as France and Britain carved up the Ottoman empire.

Since Tuesday, black-clad ISIL fighters who do not recognise the region's modern frontiers have seized Mosul and Tikrit, Saddam's home town, and other towns and cities north of Baghdad.

The army has evaporated in the face of the onslaught, abandoning bases and U.S.-provided weapons. Online videos showed purportedly a column of hundreds, possibly thousands, of troops without uniforms being marched under guard near Tikrit.

Obama has come under fire for failing to do enough to shore up the government in Baghdad before pulling out its troops. Security and police sources said Sunni militants now controlled parts of the town of Udhaim, 90 km (60 miles) north of Baghdad, after most of the army troops left their positions and withdrew towards the nearby town of Khalis.

“We are waiting for reinforcements and we are determined not to let them take control," said a police officer in Udhaim. "We are afraid that terrorists are seeking to cut the main highway that links Baghdad to the north."

ISIL and its allies took control of Falluja at the start of the year. It lies just 50 km (30 miles) west of Maliki's office.

OIL PRICE SURGE

The U.N. Security Council was expected to meet later on Thursday. Iraq's ambassador to France said it would call for weapons and air support: "We need equipment, extra aviation and drones," Fareed Yasseen said on French radio.

The Council "must support Iraq, because what is happening is not just a threat for Iraq but the entire region."

The global oil benchmark jumped about $2 on Thursday, as concerns mounted that the violence could disrupt supplies from the OPEC exporter. Iraq's main oil export facilities are in the largely Shi'ite areas in the south and were "very, very safe", oil minister Abdul Kareem Luaibi said.

ISIL fighters have overrun the town of Baiji, site of the main oil refinery which meets Iraq's domestic demand for fuel. Luaibi said the refinery itself was still in government hands but late on Thursday police and an engineer inside the plant said insurgents were surrounding it.

Militants have set up military councils to run the towns they captured, residents said. "They came in hundreds to my town and said they are not here for blood or revenge but they seek reforms and to impose justice. They picked a retired general to run the town,” said a tribal figure from the town of Alam.

“'Our final destination will be Baghdad, the decisive battle will be there,' that’s what their leader kept repeating," the tribal figure said from Alam, north of Tikrit.

Security was stepped up in Baghdad to prevent the Sunni militants from reaching the capital, which is itself divided into Sunni and Shi'ite neighbourhoods and saw ferocious sectarian street fighting in 2006-2007 under U.S. occupation.

By midday on Thursday insurgents had not entered Samarra, the next big city in their path on the Tigris north of Baghdad.

“The situation inside Samarra is very calm today and I can’t see any presence of the militants. Life is normal here,” said Wisam Jamal, a government employee in the mainly Sunni city which houses a major Shi'ite pilgrimage site.

LOW MORALE

The million-strong Iraqi army, trained by the United States at a cost of nearly $25 billion, is hobbled by low morale and corruption. Its effectiveness is hurt by the perception in Sunni areas that it pursues the hostile interests of Shi'ites.

During the U.S. occupation, Washington encouraged Maliki to reach out to the Sunni minority that lost power after Saddam's fall. But since the U.S. withdrawal, Maliki pushed Sunnis out of his ruling coalition, creating resentment insurgents exploit.

The Obama administration had tried to keep a contingent of troops in Iraq beyond 2011 to prevent a return of insurgents, but failed to reach a deal with Maliki's government.

Iraq's parliament was meant to hold an extraordinary session on Thursday to vote on declaring a state of emergency, but failed to reach a quorum, a sign of the sectarian political dysfunction that has paralysed decision-making in Baghdad.

The Kurdish capture of Kirkuk overturns a fragile balance of power that has held Iraq together since Saddam's fall.

Iraq's Kurds have done well since 2003, running their own affairs while being given a fixed percentage of the country's overall oil revenue. But with full control of Kirkuk - and the vast oil deposits beneath it - they could earn more on their own, eliminating the incentive to remain part of a failing Iraq.

Maliki's army already lost control of much of the Euphrates valley west of the capital to ISIL last year, and with the evaporation of the army in the Tigris valley to the north, the government could be left with just Baghdad and areas south.

Iran, which funds and arms Shi'ite groups in Iraq, could be brought deeper into the conflict, as could Turkey to the north.

In Mosul, 80 Turkish citizens were being held hostage by ISIL after its consulate there was overrun.

Maliki described the fall of Mosul as a "conspiracy" and said the security forces who had abandoned their posts would be punished. In a statement on its Twitter account, ISIL said it had taken Mosul as part of a plan "to conquer the entire state and cleanse it from the apostates" - meaning Shi'ites.

Militants were reported to have executed soldiers and policemen after their seizure of some towns.

ISIL, led by Abu Bakr al-Baghdadi, broke with al Qaeda's international leader, Osama bin Laden's former lieutenant Ayman al-Zawahri, and has clashed with al Qaeda fighters in Syria.

In Syria, it controls swathes of territory, funding its advances through taxing local businesses, seizing aid and selling oil. In Iraq, it has carried out regular bombings against Shi'ite civilians, killing hundreds a month.

(Additional reporting by Ghazwan Hassan in Tikrit and Jeff Mason, Steve Holland and Roberta Rampton in Washington; Writing by Peter Graff; Editing by Philippa Fletcher and Alastair Macdonald)

(Reuters) -