NEW DELHI (REUTERS) - A case in which two Italian marines are accused of killing two Indian fisherman could now be heard before an international court, offering a possible way out of a three-year impasse that has blighted bilateral relations.

India's highest court on Monday heard a plea from Italy challenging India's jurisdiction in the murder case and ordered the Indian government to report back by Aug 26.

An Indian government lawyer told the Supreme Court that India would participate in arbitration proceedings foreseen under a United Nations convention, but argue that India should still have jurisdiction.

Massimiliano Latorre and Salvatore Girone have been in legal limbo since their arrest by India in connection with the fatal incident off the coast of southern India in February 2012.

The pair, part of a military team protecting a cargo ship, say they mistook Indian fishermen for pirates and fired warning shots. Two fishermen were killed.

Amid legal wrangling, India's Supreme Court allowed Latorre home for heart surgery, which he underwent in January. On Monday, the court allowed Latorre to stay in Italy for a further six months.

Girone is currently at the Italian embassy in India awaiting trial.

Rome objects to holding a murder trial in India, arguing that the case should be taken to arbitration under the United Nations Convention on the Law of the Sea (UNCLOS), arguing that the incident happened in international waters.

In a statement, its foreign ministry said: "The Indian government's decision to participate in the international arbitration we started ... confirms the consolidation of the judicial path taken by Italy."

FALLOUT

The Indian government lawyer who attended the hearing said, however, that New Delhi would argue at an arbitration hearing that the murder case should still be held in India. "It is wrong to say that India had agreed to arbitration. Rather we would contest it," Additional Solicitor General P.S. Narasimhan told Reuters. "India would contest the plea of the Republic of Italy in the arbitration and would contend that India would alone have the jurisdiction to try the offences committed by the two Italian marines."

The fallout from the arrest of the two marines has damaged wider relations, contributing to the collapse of a European Union-India summit planned during Prime Minister Narendra Modi's visit to France and Germany this spring.

In April 2012, Rome paid US$190,000 to each of the victims'families as compensation. In return, the families dropped their cases against the marines, but the state's case has yet to come to trial.