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RABAT (Reuters) - Libya's powerful old guard appears to be holding up the appointment of Muammar Gaddafi's western-leaning son to a top government role, leaving prospects for reform in the north African country as murky as ever.

Libya has emerged from years of diplomatic isolation and begun to cooperate with the West on security and migration.

Companies like BP and Exxon Mobil re spending billions of dollars to tap Africa's biggest proven oil reserves.

But establishment conservatives remain deeply suspicious of foreign interference and hopes have dimmed that the end of sanctions would mean greater political openness, deeper trade ties and a transparent business environment.

Reform advocates found a reason for optimism in October when Gaddafi named his son Saif al-Islam, who negotiated Libya's exit from sanctions, to be head of the Social Popular Leadership.

The grouping of business, union and political leaders was established in the 1980s to give a voice to tribal interests that underpin his father's system of grass-roots government.

The Leadership is viewed as less tainted by corruption than other areas of government and the appointment would have made Islam the country's second-most powerful figure.

But Islam has not taken up his new functions and the issue did not come up for discussion last month at the General People's Congress, Libya's top consultative body.

A high ranking Libyan official told newspaper Asharq al-Awsat on condition of anonymity that Saif al-Islam was not about to assume an official government role and was sticking to a decision made in 2008 to retire from public life.

Experts say Islam may be just biding his time.

"We believe that the Leader is still determined that Saif al-Islam will become Coordinator of Social People's Leadership and that Saif will begin to manage the day-to-day running of domestic affairs," said Charles Gurdon, a Libya expert at London-based consultancy Menas Associates.

BUILDING SUPPORT

Libya analysts say Islam wants power and needs to build support among ordinary Libyans to sideline the old guard and win over senior figures like Foreign Minister Musa Kusa and former intelligence head Abdullah Senusi.

Islam's supporters say he will enter government when Libyans gain more political freedom and transparent state institutions.

"I think Saif is genuinely interested in building popular support and sees these appeals to democratization and reform as a way to do so," said Geoff Porter, an analyst at Eurasia Group.

Saif al-Islam suffered a blow last month when two newspapers owned by Al Ghad, a media company that he helped establish, suspended publication.

The papers had published articles alleging official corruption, but media industry sources told Reuters the papers were closed because the company failed to pay its printing bill for many months. The titles are still publishing online.

The government already took control of Al Ghad's TV channel Al Libia last year and analysts said the group's troubles were damaging Islam's image as a manager and decision maker.

"Outside observers often fail to realise that organisations and companies related to Saif (al-Islam) have shown quite a dismal performance, often worse than the public sector in terms of management, honesty and lack of professionalism," said Tripoli-based political analyst and professor Mustafa Fetouri.

DISGRUNTLED LIBYANS

The end of sanctions allowed goods to flood into Libya and inflation is gnawing at incomes, focusing frustration at the government's apparent failure to improve living standards.

Growing oil income still pays for generous subsidies and government salaries. Gaddafi has watered down the centralized economy and state-run markets that once offered only bare necessities now sell many appliances and household goods.

But ordinary Libyans complain of bad schools and utilities, archaic banks and elephantine bureaucracy.

Many say that fortune in Libya favours the well-connected, who speed around Tripoli in luxury SUVs and whose fat wallets have enticed a host of luxury retailers to open stores there.

Islam has spent years cultivating an image as a reformer with the influence to challenge corrupt apparatchiks, make government more transparent and strengthen the judiciary so it can stand up to powerful interests.

Libya watchers say he is clearly being groomed to succeed his father but conservatives will throw obstacles in his way.

"Most of (Islam's) projects have failed because ... fat cats seek to undermine every development project Libyans need and Saif wants," wrote political analyst Tahani Darb on pro-reform Web site Jeel-Libya.

Yet advocates of institutional reform say Islam still has a far better chance of leading the government than his brothers such as Mutassim Gaddafi, Libya's national security adviser who made a rare public appearance in Washington last year.

"We never heard Mutassim speak, never heard him say what he believes in," said London-based analyst and Libyan exile Ashur Shamis. "Personally he has hardly any loyalty or following."