NEW YORK (REUTERS) - A US judge said on Friday Argentina must reverse the steps it has taken to evade his orders in a longstanding dispute with hedge funds over debt the country defaulted on in 2002.

In a rare move, District Judge Thomas Griesa held Argentina in contempt earlier this week, saying its attempts to pay holders of the bonds it restructured in 2005 and 2010 debt swaps locally were "illegal". The judge prevented Argentina in June from making a coupon payment to exchange bondholders because of his earlier ruling that the South American country could only do so if it paid the US "holdout" funds, who rejected the swaps, at the same time.

The move plunged Latin America's third largest economy into its second default in 12 years.

Leftist President Cristina Fernandez's government responded by enacting a law removing trustee Bank of New York Mellon Corp and allowing the country to make payments locally to keep the money beyond Griesa's reach. "Argentina will need to reverse entirely the steps which it has taken constituting the contempt, including, but not limited to, re-affirming the role of The Bank of New York Mellon as the indenture trustee," Griesa said in an order, noting this was what it would take to purge his contempt finding.

Defiant, the country this week deposited a US$161 million bond interest payment with a newly appointed local trustee, state-controlled Nacion Fideicomisos.

Griesa, who has overseen litigation in New York over Argentina's debt for years, said on Friday the country must "(withdraw) any purported authorisation of Nacion Fideicomisos, S.A. to act as the indenture trustee." The judge's decision to hold a foreign government in civil contempt of court is a rare but not unprecedented move. In typical cases, US judges can hold parties in contempt and issue sanctions to force compliance.

The hedge funds had proposed a daily fine of US$50,000. However, Argentina might simply ignore any monetary sanction. Griesa has not set a specific schedule to consider sanctions.