NEW YORK (Reuters) - A U.S. judge has refused to dismiss Allied Irish Banks Plc's (>> Allied Irish Banks PLC) lawsuit accusing Citigroup Inc (>> Citigroup Inc) of helping rogue currency trader John Rusnak rack up a $691 million loss.

In a decision on Tuesday, U.S. District Judge Deborah Batts in Manhattan said government-controlled AIB may pursue a variety of fraud claims against Citigroup in its lawsuit seeking $500 million of compensatory damages plus punitive damages.

She dismissed two other claims against Citigroup, the third-largest U.S. bank by assets.

Rusnak committed the fraud at AIB's Allfirst Bank in Baltimore, where he hid mounting trading losses for at least five years before they were revealed in February 2002.

The scandal was one of the largest involving rogue trading then on record. Rusnak later pleaded guilty to one count of bank fraud, and served nearly six years of his 7-1/2 year prison term. He was released in January 2009.

AIB accused Citibank, Allfirst's prime broker, of furthering the fraud by engaging in Rusnak's sham transactions, including disguised cash advances and fake trades.

As a result, Rusnak traded more than Allfirst permitted, and pretended he was making legitimate currency bets, AIB said.

Citigroup countered that the evidence "does not come even close" to suggesting it contributed to Rusnak's losses, fraudulently or otherwise.

Batts nonetheless found "credible" evidence the bank misled AIB about Rusnak's trades, and did not try to verify their legitimacy.

"Given how lucrative Rusnak's trading was to Citibank, it would not be far-fetched to infer that Citibank did so because it was motivated to keep Rusnak happy," she wrote.

The judge also said Citibank's activity might have delayed discovery of the fraud, and that Rusnak's "unorthodox requests" to the bank could have raised a red flag.

Citigroup spokesman Scott Helfman declined to comment. Alan Levine, a partner at the Cooley law firm representing AIB, said: "We look forward to the trial."

Batts issued her 40-page decision nearly three years after both parties last submitted legal papers. No trial date is set.

AIB originally also sued Bank of America Corp (>> Bank of America Corp) over its dealings with Rusnak, but dropped the lawsuit in January 2012.

The Irish lender sold a majority of Allfirst to Buffalo, New York-based M&T Bank Corp (>> M&T Bank Corporation) in 2003.

The case is Allied Irish Banks Plc v Citibank NA, U.S. District Court, Southern District of New York, No. 03-03748.

(Editing by Jeffrey Benkoe)

By Jonathan Stempel