TOKYO, July 24, Reuter - Prime Minister Sosuke Uno, under fire for an alleged affair with a geisha, announced he would quit on Monday after Japan's ruling party suffered the worst electoral setback in its history.

The Liberal Democratic Party, which has helped make Japan the world's number two economic power during its 34 years of continuous rule, lost its majority in the upper house of parliament, largely due to public anger over a new sales tax.

The big winner was the Japan Socialist Party, once dismissed as incapable of mounting a serious challenge to the entrenched, conservative LDP.

The JSP, under chairwoman Takako Doi, rode a wave of outrage against the three per cent sales tax slapped on all consumer goods and services in April, winning seats both from the LDP and from other opposition groups.

It also won huge support from farming areas which in the past always voted solidly for the LDP. Farmers are incensed over LDP concessions to the West on farm imports and suspect the party may agree to demands that Japan allow rice imports.

The Recruit shares-for-favours scandal, in which virtually the entire leadership of the LDP has been implicated, appeared to trigger the defection of large numbers of solid LDP supporters to the JSP.

Half the 252 seats in the upper house were at stake in the election, and the LDP ended up with a total of 109 in the chamber, far less than the 127 needed for a majority. The JSP now has 66 seats.

The LDP retains its hold on government by virtue of its majority in the lower house of parliament, but the magnitude of Sunday's defeat could force the party to hold a general election as early as September, political analysts say.

In any event, a hostile upper house could paralyse parliamentary business and make it virtually impossible for the LDP to have legislation passed without compromising with the opposition every step of the way, political analysts say.

The LDP, reeling from the depth and range of opposition from different sections of Japanese society, was also grappling with the task of finding a replacenment for Uno, who said he would stay on until a successor is chosen.

"The LDP has had a hardening of the arteries in the past 15 years," said Kent Calder, a political scientist from Princeton University in the United States. "They'll find it difficult finding a really attractive leader to make the generational shift."

Doi said her first move would be to introduce a bill to abolish the sales tax, but LDP leaders continued to insist the tax was necessary despite its obviously poisonous electoral effects.

Some analysts said the result indicated Japan was moving towards a two-party political system, in which the LDP could no longer automatically count on monopolising power.

Others were more pessimistic, saying the vote was basically a knee-jerk reaction by the conservative electorate again the LDP attempts to introduce change too fast.

"Japan is going to become more isolated, more inward-looking and protectionist as a result of this," said one political commentator.

The Socialist Party's Doi, basking in the party's biggest-ever victory, emphasised the new, more compromising policy approach of the JSP, even suggesting the U.S.-Japan security treaty, which the party opposes, could be maintained with modifications.

"If we allow it to continue, there are some aspects we cannot allow to remain unchanged," she told reporters.

She indicated the JSP would particularly push for an end to some aspects of U.S. military activity in Japan under the security treaty. The United States is widely believed to store nuclear bombs on bases in Japan in contravention of the treaty.

Masayoshi Ito, a revered party elder who was actively courted to replace Uno's predecessor Noboru Takeshita, told reporters he would refuse the premiership again.

"I've already refused to be prime minister," Ito said. "That has not changed."

Ito said Uno alone was not responsible for his party's debacle. "There were plenty of people responsible for the LDP's defeat. I feel sorry for Uno," he said.

The Liberal Democratic Party, with political liability Uno gone, is expected to regain lost ground in general elections because many voters fear an opposition victory more than continued LDP rule, analysts said.