U.S. light, sweet crude fell $1.87 to $42.73 a barrel by 8:15 p.m. ET after dipping by more than $2 earlier, reversing a part of Wednesday's $5.57 a barrel gains. Oil tumbled 54 percent in all last year.

Oil products helped trigger the surge on the last trading day of 2008 after weekly U.S. data showed a fall in refinery activity and an unexpected 500,000-barrel rise in crude stocks, stoking worries that fuel supplies could grow tight.

Inventories of refined products also rose, though less than analysts had expected. Gasoline stockpiles increased by 800,000 barrels, less than forecasts for a 1.5 million barrel build, while distillates rose by 700,000 barrels, below expectations for a 1.1 million barrel increase.

But demand also remained lower than a year ago, underscoring the dual impact of last year's record high prices followed by a deepening economic recession, which combined to knock oil prices more than $100 off their $147 a barrel July peak.

Demand is also faltering in emerging Asia, with Chinese commercial fuel stocks rising to another record high in November, while Indian refinery production fell versus a year ago for the first time in three years.

"(Oil demand) data in recent days have been more positive in the cases of the US and the UK, and weaker in the cases of Japan and China," Barclays Capital wrote in a report.

Faced with slumping demand and prices, producer grouping OPEC last month agreed to cut output 2.2 million barrels per day (bpd), its deepest reduction ever, taking its total reduction since September to the equivalent of 5 percent of world supply.

Evidence is mounting that OPEC is complying with its goal to reduce production, led by top exporter Saudi Arabia.

GEOPOLITICS SUPPORT

Oil markets have also watched anxiously the dispute between the world's biggest non-OPEC oil exporter, Russia, and its neighbors over natural gas supplies.

Russia shut off the gas to neighbor Ukraine on Thursday after a contract dispute but increased supplies to other European states to try to reassure customers.

The row could stir new doubts about Moscow's reliability as an energy supplier and fuel suspicions in the West -- already running high since Russia's war with Georgia last August -- that the Kremlin bullies its pro-Western neighbors, although similar past disputes rarely had an impact on oil flows.

Violence in Gaza that stoked oil's rise this week continued into a sixth day on Thursday, when Israel killed a senior Hamas leader in its first deadly blow against the top ranks of the Islamist group in an offensive that has claimed more than 400 Palestinian lives.

International calls grew for an immediate ceasefire in the deadliest conflict in the Gaza Strip in four decades, which has killed at least 412 Palestinians and wounded some 1,850, as Israel seeks to stop rocket attacks into its territory. About a quarter of the dead were civilians, the U.N. estimated.

(Reporting by Jonathan Leff, additional reporting by Chua Baizhen; Editing by Michael Urquhart)