By Noah Barkin and Jeff Mason

KRUEN, Germany (Reuters) - U.S. President Barack Obama accused President Vladimir Putin of wrecking Russia's economy in a doomed drive to recreate the glories of the Soviet empire and G7 leaders said they could step up sanctions against Moscow if violence in Ukraine escalated.

At the conclusion of a Group of Seven summit in the Bavarian Alps, leaders expressed concern about an upsurge in fighting in eastern Ukraine, where Russian-backed separatists have clashed with Kiev's troops in violation of a ceasefire agreed in April.

The strongest rhetoric came from Obama, who told a news conference the Russian people were suffering severely because of Putin's policies.

It was the second summit of the group of leading industrial nations to exclude Russia since Putin was frozen out of what used to be the G8 after Moscow's annexation of Crimea last year, a move the G7 condemned in their communique as "illegal".

"He's got to make a decision," Obama said of Putin. "Does he continue to wreck his country's economy and continue Russia's isolation in pursuit of a wrong-headed desire to recreate the glories of the Soviet empire, or does he recognize that Russia's greatness does not depend on violating the territorial integrity and sovereignty of other countries."

The Kremlin played down Putin's absence from the summit, saying he preferred "other formats" that were more effective and better reflected the balance of global economic power.

"It's impossible now to get together in seven or eight people and effectively discuss global problems," RIA news agency quoted Kremlin spokesman Dmitry Peskov as saying.

G7 sources said the Ukraine crisis and how to handle Russia had taken up two-thirds of the discussion at a Sunday dinner devoted to foreign policy.

One source, describing the Ukraine economy as a "catastrophe", said there was a consensus among the leaders that the country could not be allowed to fail.

Canada's Stephen Harper and Japan's Shinzo Abe both visited Kiev before the G7 summit and voiced strong support for President Petro Poroshenko, the sources said.

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SANCTIONS

German Chancellor Angela Merkel, the summit host, who has led diplomacy to engage Putin in a diplomatic solution to the conflict, told reporters that sanctions against Russia could be lifted if Moscow and the separatists fully implemented a peace deal struck in the Belarus capital Minsk earlier this year.

But she added that Europe and the United States were also prepared to toughen sanctions. German officials said this would be necessary if separatists seized more territory in eastern Ukraine, especially around the strategic port city of Mariupol.

Poroshenko told his military last week to prepare for a "full-scale invasion" by Russia in response to an upsurge in fighting, which has gone far beyond the low-level skirmishing seen in recent months.

"As we've seen again in recent days, Russian forces continue to operate in eastern Ukraine, violating Ukraine's sovereignty and territorial integrity," Obama said.

"Russia is in deep recession. So Russia's actions in Ukraine are hurting Russia and hurting the Russian people. And the G7 is making it clear that if necessary we stand ready to impose additional significant sanctions against Russia."

(Additional reporting by Paul Carrel, Paul Taylor, Michelle Martin in Kruen, Gabriela Baczynska in Moscow; Writing by Noah Barkin)