VIENNA - Iran has increased its capacity to refine uranium by installing hundreds more centrifuges, a UN nuclear agency report said on Wednesday, underlining Tehran's defiance of Western demands to curb the activity.

But, in a development that could help buy time for diplomacy between Iran and world powers, the report showed limited growth of Iran's most sensitive nuclear stockpile and it remained below an Israeli "red line" for possible action.

Tehran's holding of medium-enriched uranium gas is closely watched as Israel says it must not amass enough for one bomb if further processed and has threatened air strikes if diplomacy and sanctions do not stop Iran's atomic drive.

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The report by the International Atomic Energy Agency (IAEA) indicated that Iran was pressing ahead with the construction of a research reactor that Western experts say could offer it a second way of producing material for a nuclear bomb, if it decided to embark on such a course.

Iran has transported the reactor vessel to the heavy water plant near the central town of Arak but has not yet installed it, the International Atomic Energy Agency (IAEA) said in a confidential report issued to member states.

Western concerns about Iran are focused largely on uranium enrichment plants at Natanz and Fordow, as such material refined to a high level can provide the fissile core of an atomic bomb.

But experts say Arak may also be a proliferation issue as it could yield plutonium for nuclear arms if the spent fuel were reprocessed. Iran has said it has no fuel reprocessing plans.

"Once the reactor operates, it could spawn more than enough weapons-grade plutonium for a bomb per year, should Iran ever decide to do that," said nuclear expert Mark Hibbs of the Carnegie Endowment think-tank.

The Islamic Republic, which denies it has any intention of acquiring nuclear arms, plans to commission the plant in the first quarter of 2014, the IAEA said.

In its previous report on Iran, in February, the UN agency said Iran had almost completed installation of cooling and moderator circuit piping in the facility.

Tehran last year postponed the planned start-up from the third quarter of 2013, a target that Western experts said always had seemed unrealistic.

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