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VIENNA (Reuters) - The city of Vienna has set a precedent for the restitution of artworks expropriated under the Nazi regime by this week giving up a piece that a German Jewish banker was forced to auction in 1934.

The city council chose to return the artwork to the heirs of Herbert Gutmann even though the Austrian law for art restitution only covers the period between 1938, when Austria was annexed by Nazi Germany, and 1945, when the Third Reich was defeated.

"It was about ... overruling the timeframe of the current restitution law in view of a moral obligation," said Andreas Mailath-Pokorny, Vienna city councillor for culture.

Herbert Gutmann was a wealthy Jewish banker, the son of a co-founder of Dresdner Bank, Eugen Gutmann.

Forced out of the banking world after the Nazis came to power in Germany in 1933, he sold his art collection and other possessions and fled to Britain in 1936.

The Museum of Vienna acquired the painting "Pappenheim's Death," by Hans Makart, from a Danish art dealer in 1968, but this week handed it back to Gutmann's grandchildren.

"We hope the other pieces once belonging to our grandfather and which we are currently pursuing will be restored to the family soon," Gutmann's heirs said in a statement.

The case sets a precedent in Austria, which said last year it wanted to tighten restitution rules and seek the return of works taken between 1933, when Hitler first came to power in Germany, and 1945.

The government's move was prompted by criticism from the Austrian Jewish community that it was not doing enough to guarantee art restitution, and the law is likely to be amended this year.

"This is a milestone in the history of the restitution process," said historian Michael Wladika and restitution specialist at the Museum of Vienna.

"Vienna took special measures given that this was clearly a case of expropriation."

Property belonging to Jews was confiscated as a matter of course during Nazi rule in Germany and neighbouring countries.

Thousands of art works have been returned to their original owners or their heirs under Austria's present art restitution law, include five paintings by art Nouveau master Gustav Klimt.

One of the five returned to the Bloch-Bauer family who originally owned them was sold for $135 million (92 million pounds) in a private sale, believed to be the highest price ever paid for a painting.

The remaining four fetched a combined $192.7 million at an auction at Christie's in November, 2006.

(Editing by Mike Collett-White and Paul Casciato)