* SPD and Greens win key regional election by single seat
* Merkel concedes narrow defeat in Lower Saxony "hurts"
* Victory gives left blocking majority in upper house
* FDP leader keeps post after surprisingly strong result
By Noah Barkin
BERLIN, Jan 21 (Reuters) - In an extremely tight German state election that seemed to produce few clearcut winners, there was no question who the biggest loser was - Angela Merkel.
Her Christian Democrats (CDU), led by local star David McAllister, had convinced themselves over the past week that they were on the verge of a come-from-behind victory to keep control of Lower Saxony, a vast agricultural and industrial region that resembles a U.S.-style swing state.
But on Sunday, they came up short, losing the state to the centre-left Social Democrats (SPD) and Greens, who together won one more seat in the state assembly than the centre-right.
In one fell swoop, the result gives the centre-left a majority in the Bundesrat upper house of parliament, meaning the opposition can block major legislation from Merkel's government and initiate laws themselves.
It is a bitter defeat for the 58-year-old chancellor, even if she remains popular and a strong favourite to win a third term in a federal election eight months from now.
"I'm not going to pretend. After all the feelings generated by this election, defeat hurts even more," Merkel told a news conference in Berlin, standing alongside a gloomy-looking McAllister. "We are all sad today. Sad that it didn't work out."
The centre-left will keep control of the upper house after the national election in September, even if Merkel's centre-right coalition with the liberal Free Democrats (FDP) manages to hold onto power.
In the run-up to the vote, Merkel's room for manoeuvre will be limited, and the notoriously risk-averse German leader may take a more cautious stance on a range of policy issues, including the euro zone debt crisis.
"Barring some sort of emerging immediate threat to eurozone stability, we see little prospect of any major measures to address the fundamentals of the eurozone crisis being agreed and implemented this side of Germany's federal election," said Alastair Newton of Nomura.
The vote is also a blow to the CDU's brightest new light. McAllister, a 42-year-old with a Scottish father, had ruled Lower Saxony since 2010 and became a protege of the chancellor, declaring on the vote's eve he was glad to be "Merkel's Mac".
There will be hand-wringing in the CDU about McAllister's not-so-subtle hints to supporters before the election that they use one of their two votes to boost the score of the FDP.
To keep power, McAllister needed the CDU's struggling FDP allies to make the 5 percent threshold to win seats in the state assembly. His message resonated with CDU voters, but perhaps stronger than he would have liked: the FDP ended up with a surprisingly strong 9.9 percent, largely thanks to CDU backers.
Its gains appear to have come at the expense of the CDU, which scored 36 percent, down 6.5 points from their last result in Lower Saxony in 2008 and well below the 40 percent-plus that opinion polls had forecast.
"The CDU has now seen very clearly how bad things can go when you campaign for a split vote, as it did for the benefit of the FDP," said Oskar Niedermayer, a political scientist at Berlin's Free University.
Merkel's CDU has now suffered defeats to the SPD and Greens in five states over the past two years, including in their longtime southern stronghold of Baden-Wuerttemberg and in Germany's most populous state, North Rhine-Westphalia.
Of Germany's 16 federal states, only three are now ruled by centre-right coalitions like her federal partnership in Berlin.
The string of losses will fuel anxiety about Merkel's ability to leverage her own popularity into votes for her party.
"Frau Merkel is a queen without a country," said senior SPD politician Andrea Nahles.
The FDP were hailed as the big winners of Sunday's vote, but the result failed to silence internal critics who want to jettison national party leader Philipp Roesler.
At a closed-door FDP leadership meeting on Monday in Berlin, Roesler offered to cede the chairmanship to parliamentary leader Rainer Bruederle, a party source told Reuters. An FDP spokesman later said Roesler would remain as party head, but Bruederle would take charge of the looming federal election campaign.
The SPD will take some satisfaction after seeing their colourless candidate, Hanover Mayor Stefan Weil, oust the popular Merkel ally McAllister. But the narrow victory does not give them the major momentum-boost they had been hoping for.
Instead it highlighted the problems of their own chancellor candidate Peer Steinbrueck, who on Sunday accepted blame for weakening the party in Lower Saxony with a series of gaffes.
The result is unlikely to quiet voices within the SPD who question Steinbrueck's suitability as a challenger to Merkel, even if the party tried to present a united front on Monday.
The only party that came out an undisputed winner from Lower Saxony was the Greens, who with 13.7 percent of the vote scored their best ever result in the state. But without a stronger performance from the SPD, their natural allies, the environmentalist party has little hope of dislodging Merkel.
"It seems very likely that Ms. Merkel will stay in power one way or another," Jennifer McKeown of Capital Economics said. "But the most likely general election outcome at this stage seems to be that the CDU is forced to form another cumbersome grand coalition with the SPD."