AIG said the agreement with the government would allow it to pay down what it owed in a special purpose vehicle, AIA Aurora, and free up the company's collateral against that, including interests in aircraft lessor International Lease Finance Corp and Asian insurer AIA Group Ltd.

The special purpose vehicle was set up in December 2009 in exchange for a reduction in the debt that AIG owed the New York Federal Reserve at the time. The Treasury's original interest in the vehicle was $16 billion.

The stake sale is expected reduce the government's ownership in AIG to about 70 percent from 77 percent, a source with knowledge of the situation said. Once the company repays Treasury for the special vehicle interest, the value of the government's stake would total about $41.8 billion.

The announcements come as President Barack Obama, a Democrat, fights to win a second term in office and withstands attacks from Republicans for wasting taxpayer money.

"The bottom line is this: the people of AIG have achieved another significant milestone in our progress toward our goal that American taxpayers recoup their entire investment in AIG at a profit," AIG Chief Executive Robert Benmosche said in a statement.

Earlier this week, AIG sold part of its stake in AIA to raise about $6 billion to repay the government. Following the share sale, AIG holds about 19 percent of AIA.

STOCK PRICE RUN-UP

AIG had to be rescued during the financial crisis of 2008 through multiple bailouts, under both the Obama and Bush administrations, with the government at one point pledging some $182 billion to keep the insurer afloat.

In the last few years, Benmosche has been trying to steady the ship and selling off non-core assets to pay back the government.

Last month the company reported a net profit of nearly $20 billion for the fourth quarter. While the outsized profit was a one-time event linked to a tax accounting change, underlying it was a long-term assumption that the company has stopped its multibillion dollar crisis-era losses.

The share sale plan comes as AIG's stock price has run up some 27 percent this year, possibly giving the government an opportunity to offload some of its stake without having to take a loss. For the government to break-even on its investment in AIG, it needs to sell shares at about $29.

The stock closed up 1.4 percent on Wednesday at $29.45, although it fell about 1.9 percent in aftermarket trading following the announcements.

The source said the shares have not been priced yet. Treasury declined to comment on the pricing.

PLAN DETAILS

Under the latest plan, AIG intends to repurchase up to $3 billion of its stock in the Treasury's offering once it is priced. The Treasury will also grant an option to the underwriters for the offering to purchase an additional $900 million worth of stock.

The government hired Citigroup Inc, Credit Suisse and Morgan Stanley to coordinate the offering, choosing a different set of bankers than AIG had when it first sold stock early last year.

The choice is a reversal in fortunes for the two U.S. investment banks. Citigroup and Morgan Stanley had played key roles in the insurer's restructuring but were left out of the coveted lead bookrunner roles in the offering last year.

AIG is expected to repay the $8.5 billion owed under the AIA vehicle with proceeds from several sources, the Treasury said.

The company expects to pay $5.6 billion from the sale of the AIA stake. It expects to get $1.6 billion in escrowed cash proceeds from an earlier sale of its life insurance unit, American Life Insurance Co, to MetLife Inc.

AIG also expects to get $1.6 billion as the Federal Reserve Bank of New York sells off the last of the securities held in Maiden Lane II LLC, a vehicle that was created to buy mortgage backed securities from AIG during the financial crisis as part of its bailout.

(Additional reporting by Paritosh Bansal in Toronto, Editing by Gary Crosse, Bob Burgdorfer and Muralikumar Anantharaman)

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