COLOMBO One year after the Sri Lankan military's most stunning defeat in nearly two decades of fighting Tamil Tiger rebels, the loss of Elephant Pass can be viewed as a major step toward peace talks, analysts said.

They said the military debacle, which took place 12 months ago on Sunday, triggered a skyrocketing defense bill the nation could not afford and set off soul-searching on whether the army would ever be capable of ending the ethnic conflict on the battlefield.

And after expectations that the Liberation Tigers of Tamil Eelam (LTTE) would ride the Elephant Pass victory all the way into Jaffna City failed to come true, it also hammered home to the rebels that they could not win either, the analysts said.

"It may have been a turning point because both parties realized that they cannot win militarily," said one Western diplomat, cited by Reuters.

"They now know they should talk," he said, referring to developments over the last six months in which fighting has dropped off and the two sides have inched closer to the negotiating table.

Almost 300 government soldiers were killed when the LTTE overran the Elephant Pass base in a massive onslaught that took them to the gates of Jaffna City.

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The loss of the huge military base which guarded the isthmus gateway to the Jaffna peninsula was the army's worst defeat since the LTTE started fighting in 1983 for a separate Tamil state in the country's north and east.

The rebels then marched up the peninsula, forcing the government into an arms-buying spree that blew a hole in its defense budget.

Defense spending in 2000 ballooned to $1 billion, helping drive up the budget deficit to 9.8 percent of gross domestic product from a forecast 7.6 percent.

That ravaged the country's economic fundamentals, driving the stock market to all-time lows and clipping almost 15 percent off the value of the rupee.

Diplomats said that in addition to not being able to push home their advantage militarily, the rebels -- who got within 5km (three miles) of Jaffna City before being driven back -- might have been shocked by how willing other countries were to help Sri Lanka.

"After Elephant Pass, everyone thought Jaffna was going to fall, but the government appealed for international help and the LTTE got the message that the international community did not want Jaffna to fall to the LTTE," said a second diplomat.

"That was a wake-up call for the LTTE."

The dramatic escalation in the fighting last year left almost 4,000 dead, according to the military, taking the estimated death toll from the 18-year conflict to 64,000.

Both sides suffered their heaviest losses in the Jaffna peninsula, which the LTTE had vowed to capture by end of the year.

"They have to know that it can only be a negotiated settlement now," said the first diplomat.

Pushed by a Norwegian-brokered initiative, the rebels are in the fourth month of a unilateral cease-fire, while the government has said it expects to announce by the end of the month a date for direct talks with the LTTE.