By Fatos Bytyci

PRISTINA (Reuters) - Kosovo's two biggest parties agreed "in principle" on Wednesday to form a government, the Balkan country's president said, signalling an end to more than five months of damaging political deadlock.

President Atifete Jahjaga made the announcement after meeting outgoing Prime Minister Hashim Thaci of the Democratic Party of Kosovo (PDK) and Isa Mustafa of the rival Democratic League of Kosovo (LDK).

"Thaci and Mustafa agreed in principle to form a coalition between PDK and LDK, to build institutions of the Republic of Kosovo," Jahjaga said in a statement.

Thaci's PDK won Kosovo's June parliamentary election but his hope of a third consecutive term as prime minister was challenged by an ad hoc opposition alliance involving the LDK.

The two sides spent the next five months arguing over the wording of the constitution on which party had the right to form the government, testing the patience of Western powers which backed Kosovo's 2008 secession from Serbia.

The U.S. ambassador to Kosovo, Tracey Ann Jacobson, was present at the meeting, Jahjaga said.

LDK, in a statement, said it would take the post of prime minister.

One newspaper reported that, under the deal, Thaci would become president in 2016 when Jahjaga's term ends. The president is elected by parliament.

"Based on the agreement, the position of the prime minister will belong to the LDK," the party said. "Division of the ministries will be decided over the coming days."

There was no immediate word from Thaci, a former guerrilla commander during the 1998-99 Kosovo war.

The former province broke away from Serbia in 1999, when NATO bombed for 11 weeks to drive out Serbian forces accused of killing and expelling ethnic Albanian civilians during a two-year counter-insurgency war.

It declared independence in 2008 and has been recognised by more than 100 countries, but not by Serbia.