* Says government "cannot negotiate with terrorists"
* Somali Islamists demand Kenya frees Muslim prisoners
* Nairobi says hostages are non-combatants, not POWs
By Duncan Miriri
NAIROBI, Jan 24 (Reuters) - Kenyan officials said on Thursday they would not negotiate with al Qaeda-allied Somali militants who have threatened to kill their Kenyan hostages unless Nairobi frees Muslims held on terrorism charges.
On Wednesday al Shabaab released a video of two Kenyan hostages seized a year ago and told Kenya to meet its demands.
Days earlier, the group said it had killed French hostage Denis Allex to avenge France's persecution of Muslims and its military operations against Islamists, including in Mali.
Colonel Cyrus Oguna, spokesman for the Kenyan military which has been battling al Shabaab in Somalia since October 2011, said the hostages shown in the video were not prisoners of war because they were non-combatants.
"The government cannot negotiate with terrorists so that is out. What al Shabaab is doing is a criminal activity that is punishable by any law. They should just release them," Oguna told Reuters.
Titled "KENYA POWS: FINAL MESSAGE", the video showed Mule Yesse Edward, a local administrator, and Fredrick Irungu, who worked for the Kenyan ministry of immigration.
Both were captured last January when the militants crossed the border into Kenya and attacked a police post in Wajir county, killing several police officers.
The video also contained a still photograph of four unidentified prisoners whom the video said were also Kenyans. Oguna said no Kenyan soldiers were believed held by al Shabaab.
Thuita Mwangi, permanent secretary at the country's ministry of foreign affairs, said he had not watched the video or read the militants' demands, but reiterated that the government had a policy of not negotiating with militants.
Al Shabaab said Kenya should release all Muslims held on terror charges and secure the release of those Muslims held in Uganda on similar charges.
Kenya has detained several suspects for alleged links with al Shabaab and extradited several to Uganda after a 2010 suicide bombing in Kampala, claimed by al Shabaab, that killed 76 people.
Security analysts describe al Shabaab as a declining force. It no longer controls much territory in Somalia and is not a threat to the Somali government or African Union forces there, they said.
"They can try to use Kenyan hostages for a small degree of tactical leverage as they try to survive against counter-insurgency operations," said Mark Schroeder, Africa-watcher for U.S.-based risk and security consultancy Stratfor.
"But if the wider jihadist world looks at al Shabaab, they would see a defeat compared to the gains others have achieved in Mali, Algeria, Libya, Yemen and beyond." (Additional reporting by Richard Lough; Editing by George Obulutsa and Andrew Roche)