By Ami Miyazaki and Taiga Uranaka

TOKYO (Reuters) - Japan's government said on Tuesday it wanted Toshiba Corp and partner Western Digital Corp to cooperate, expressing concern about an escalating dispute between the two that threatens to upend the sale of Toshiba's chip unit.

Western Digital sought international arbitration this week to stop Toshiba from selling the unit without its consent, arguing that the Japanese conglomerate has violated contracts relating to their joint venture that operates Toshiba's main semiconductor plant.

On Tuesday evening, Toshiba said it would put on hold a decision to block Western Digital employees from the joint venture chip plant as well as databases, a threat it had said it would carry out if the U.S. company did not sign a broad collaboration agreement that the two had negotiated.

CEO Satoshi Tsunakawa had said on Monday that he would make a decision on the matter on Tuesday.

"We are putting on hold a decision to limit access as we continue talks toward solving the issue," a Toshiba spokeswoman said.

California-based Western Digital is one of the bidders for the world's second biggest NAND chip producer, but is not among the frontrunners after submitting a much lower offer than other suitors, a source with knowledge of the matter has said.

"It's very important for Toshiba and Western Digital to cooperate, Trade Minister Hiroshige Seko told reporters at a regular briefing on Tuesday, although he added that the ministry did not intend to intervene in the dispute.

His comments come after media reports that one of the proposed deals under discussion among government circles is to have the chip unit - which is valued by Toshiba at at least $18 billion - brought under control of the state-backed Innovation Corporation of Japan (INCJ) fund.

INCJ and U.S. private equity firm KKR & Co LP are widely expected to be the main players in a consortium which will take part in a second round of bidding.

However, some INCJ officials are cautious about making a large-scale deal, sources familiar with the matter said, declining to be identified as they were not authorised to speak publicly about the matter. The fund has just 1 trillion yen ($8.8 billion) in its war chest for acquisitions and investment.

The Financial Times reported on Tuesday that some senior members in Prime Minister Shinzo Abe's administration have privately discussed offering up to $8 billion in government loan guarantees to support an INCJ-KKR bid.

Japan government spokesman Yoshihide Suga said, however, that there was no truth to the report. A spokeswoman for INCJ declined to comment.

Shares in Toshiba, which is depending on the sale of the chip unit to cover billions in dollars in cost overruns at its now bankrupt U.S. nuclear unit Westinghouse, slid to end down 12 percent. The cost of insuring against default for Toshiba's five-year yen debt rose 10 basis points.

"While we believe that the successful sale of its chip business is indispensable for Toshiba to remain a going concern, hurdles to realising such a goal are increasing," said Masako Kuwahara, a senior analyst at Moody's Investors Service.

Other suitors for the chip unit include Taiwan's Foxconn and U.S. chipmaker Broadcom, but are seen as less attractive options. Foxconn may face opposition due to its deep ties to China as the government has said it will block any deal that risks key technology leaving Japan, while Western Digital has said it is vehemently opposed to Broadcom.

($1 = 113.4800 yen)

(Reporting by Ami Miyazaki and Taiga Uranaka; Additional reporting by Makiko Yamazaki, Yoshiyasu Shida, Kaori Kaneko in Tokyo and Umesh Desai in Hong Kong; Editing by Edwina Gibbs)