The Markit/CIPS Manufacturing Purchasing Managers' Index (PMI) rose to a 15-month high of 51.4 in December from an upwardly revised 49.2 in November - a far stronger increase than any predicted in a Reuters poll of 24 economists.

Britain's economy is forecast to shrink 0.1 percent in the last three months of 2012. But following stronger-than-expected official services sector data late last month, Wednesday's figures boost prospects that the economy can avoid slipping into its third period of contraction since the 2008 financial crisis.

The upturn in the manufacturing index takes it above the 50-mark that separates growth from contraction for the first time since March, and breaks with poor official data, which showed a 1.3 percent fall in factory output for October.

Weak PMI figures for October and November mean the manufacturing sector probably still contracted in the fourth quarter as a whole, Markit said, but the drag on overall economic output should be less than previously feared.

"It was a pleasant start to the new year and I think it's justified," said Alan Clarke, UK economist at Scotiabank. "There's probably further improvement ahead and it will be a less negative start to the year than what we've had of late."

Markit said the gain was largely driven by domestic demand, and the figures contrast with a move deeper into contractionary territory in the survey's euro zone equivalent, also released on Wednesday.

Ten-year British government bond prices fell after the data, as it encouraged investors to pursue a move into riskier assets which started after a U.S. budget deal, driving British share prices .FTSE to their highest level since July last year.

Ten-year gilt yields rose to a two-week high of 1.969 percent after the data, and gilts underperformed German debt.

SLUGGISH OUTLOOK

However, Britain's economy is still forecast to grow by just over 1 percent this year - about half its long-run average growth rate - and economists warned against drawing too many conclusions from the survey.

"The sector seems to be showing some signs of improvement - probably as the euro zone crisis is easing a little bit and Chinese growth is bottoming out," said Rob Wood, an economist at Berenberg Bank.

"But the big picture is that the UK economy has been bouncing along the bottom over the last year," he added. "Today's figures point to stabilization rather than a return to growth."

Manufacturing makes up just 10 percent of British output, so construction and services PMIs due on Thursday and Friday will give a stronger guide to the health of the economy as a whole.

Nonetheless, the output component of the manufacturing PMI rose to 54.0 in December, its highest level since April 2011, from 50.5 in November.

New orders rose at the fastest rate since March 2011, driven by domestic demand, while export orders fell, albeit at the slowest pace since September.

"Business confidence ... remains fragile and could easily be derailed by setbacks in key export markets, notably any resurgence of the euro zone debt crisis," said Rob Dobson, the Markit economist who compiled the survey.

Britain's economy also faces headwinds from a long-term government austerity program and inflation that has proven slower to fall than the Bank of England has forecast, eating into consumers' spending power.

Wednesday's data showed continued price pressures on manufacturers, whose costs rose at the fastest rate since March, driven by chemicals, energy, food products and plastics. Manufacturers in turn raised the prices they charged at the fastest rate since April.

Employment in the sector fell marginally, showing the smallest decline since August.

(Editing by Stephen Nisbet)

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