MEXICO CITY, June 17 (Reuters) - Scientists are genetically modifying a bizarre looking Mexican salamander, which according to ancient mythology is a transformed Aztec god, in the hope its ability to regenerate body parts will one day help human amputees.

Also known as "water monsters," the half-foot-long (15-cm-long) axolotl is nearly extinct in its only remaining habitat: the polluted vestiges of Aztec canals that snake though southern Mexico City, packed with colorful boats carrying tourists and mariachi musicians.

But the slimy animal crowned with frilly gills like a headdress, beady eyes and a goofy smile, is thriving in labs where it reproduces easily. It is a darling of researchers since it can regrow injured limbs, jaws, skin, organs and parts of its brain and spinal chord.

Some other animals have the capacity to regenerate, but only salamanders can regrow so many different parts over and over again throughout their lives.

The U.S. Department of Defense has given a $6.25 million research grant to scientists studying the little creature with the aim of eventually helping the more than 1,000 soldiers who have come back from Iraq and Afghanistan with missing extremities.

In a lab in Mexico City, where biology students map the shrinking habitat of the animal, an axolotl whose leg was recently bitten off by a tank mate was already budding a tiny replica, complete with little toes.

"Humans do repair tissue but they don't repair it perfectly whereas the axolotl under certain injury conditions can go into kind of a mode where they repeat the process of the embryo," said Elly Tanaka from the Center for Regenerative Therapies in Dresden, Germany.

Tanaka has succeeded in genetically engineering axolotls using a mutant type found in the wild with no skin pigment and inserting a green-glowing gene from a jellyfish into the salamander cells to help see the process of regeneration in action.

"The skin is clear so you can see the fluorescent protein inside the live animal," Tanaka said in a phone interview. The goal is to compare and contrast with the human healing process.

After amputation in salamanders, unlike in humans, blood vessels contract quickly and limit bleeding, skin cells work fast to cover the wound site and form what is called a "blastema," a collection of stemlike cells that will eventually become the new body part.

Working alongside scientists mapping the complex genome of the axolotl, which is 10 times larger than a human genome, Tanaka and her colleagues hope to discover what allows the salamander to regrow a limb instead of a scarred stump.

Humans already have the ability to regrow missing fingertips if they are cut off above the joint. If the wound is cleaned and dressed properly, a finger can regain its shape, fingerprint and feeling on its own.

"Now, as we watch a salamander grow back an arm, we are no longer quite as mystified by how it happens. Soon humans might be able to harness this truly awesome ability ourselves," experts Ken Muneoka, Manjong Han and David Gardiner wrote in a recent article. They speculated it may be only be a decade or two until human parts can be regenerated, salamander-like.

ALMOST EXTINCT

More axolotls live in captivity than in the wild as their populations in the most isolated corners of the canals in the Xochimilco neighborhood of Mexico City has likely shrunk to as few as 400, putting them at risk of extinction.

Mexico's capital, one of the world's largest cities, was built by the Aztecs on an island in the middle of a lake now drained by centuries of Spanish colonization and urban sprawl.

The Aztecs, who ate the axolotls and used them in medicine, believed they were actually incarnations of the lightning death god Xolotl who went through metamorphosis to escape being sacrificed.

The rare axolotls are threatened by chemical run off from greenhouses on the banks of the city canals, waste water from surrounding neighborhoods and non-native fish species that compete with the salamander for food.

Luis Zambrano at Mexico's Autonomous University said if the axolotls disappear in the wild it could have implications for the future genetic diversity of the research population.

"There is a version of the (Aztec) myth, that says when the axolotls disappear, so will humanity," Zambrano said.