Though Khatami won 70 percent of the popular vote in elections last year, the outcome of this battle is far from certain. The possibility of renewed relations with the "Great Satan" is seen by hard-liners as an attempt to topple a pillar of the 1979 Islamic revolution.
An increasing number of American foreign policy heavyweights - including former Secretary of State James Baker III, earlier this month - have called for a dialogue with Iran. But MKO lobbyists have been effective in Washington.
A statement signed by 220 members of the 435-seat House of Representatives Sept. 16 demanded a review of the MKO's terrorist status, and called Clinton's detente moves "wrong-headed." The MKO, it said, was the "legitimate opposition to the Iranian regime."
Iran Radio declared that the statement "is part of the congressmen's drive to raise campaign funds in order to win in forthcoming elections, and America's Zionist circles are generous in funding candidates...."
Israeli Prime Minister Benjamin Netanyahu has repeatedly called Iran the main threat to Mideast peace, and in July Iran tested the medium-range Shihab-3 missile. Iran rejects the US-sponsored Arab-Israeli peace process as unjust, and there are signs that lack of US pressure on Israel now to revive that process has scaled down expectations.
"People here have come to realize that Israel is too big an obstacle to aim for full diplomatic relations with the US," says another diplomat. "Khatami has really hardened his vocabulary against Israel - calling it a 'racist terrorist state' - and if Iran really wanted full ties, they wouldn't be doing that. Now they are aiming only for functional ties."
Where Iran tackles terrorism
Iran still ranks first in the State Department's lineup of state sponsors of terrorism for killing a handful of opponents abroad - a tactic also openly employed by Israel, analysts note - and supporting groups Washington deems to be terrorists.
Khatami told the UN General Assembly Sept. 21 - in the most unequivocal declaration of its kind to date - that Iran deplored terrorism in every form and would do everything to fight it.
Secretary of State Madeleine Albright is reported to be against taking the MKO off the terrorist list because it would send the "wrong message" at a delicate time.