By Stanley Carvalho and Praveen Menon

ABU DHABI/KUALA LUMPUR, April 24 (Reuters) - Abu Dhabi and Malaysia have resolved a debt dispute that threatened bilateral economic ties, with a conditional $1.2 billion deal following a legal challenge by the Gulf state.

Under the terms of the agreement announced on Monday, state fund 1Malaysia Development Berhad (1MDB) will pay $1.2 billion in two instalments in July and December to Abu Dhabi's International Petroleum Investment Co (IPIC).

IPIC asked a London court to arbitrate last year in a dispute with 1MDB in which the Abu Dhabi group claimed about $6.5 billion.

1MDB, once a pet project of Malaysian Prime Minister Najib Razak, is the subject of money-laundering investigations in at least six countries. 1MDB has denied these allegations.

IPIC had guaranteed bonds issued by 1MDB, the two companies said in separate statements, but now 1MDB and Malaysia's Ministry of Finance will assume responsibility for all future interest and principal payments under two bonds issued by 1MDB Group companies, IPIC said in a filing in London.

These include the $1.75 billion 5.75 percent fixed rate notes due 2022 and $1.75 billion fixed rate 5.99 percent notes due 2022, both issued by 1MDB entities.

1MDB said payments will be made to IPIC by monetizing investment fund units.

The agreement is conditional on the Arbitration Tribunal in London making a "consent award" by May 31.

This settlement is the first major step towards addressing the concerns of IPIC, which was claiming $6.5 billion. This included the $3.5 billion in bonds, plus interest amounting to $4.8 billion, the $1.2 billion loan plus interest, and about $481 million owed to Aabar, a source told Reuters.

The person asked not to be named as they are not authorised to speak on the matter.

"The government is pleased that IPIC and 1MDB have resolved their differences in an amicable manner," the Malaysian government said in a statement.

(Writing by Saeed Azhar; editing by Alexander Smith) ((Saeed.Azhar@thomsonreuters.com; +65-64035664 ; Reuters Messaging: saeed.azhar.reuters.com@reuters.net))