By Andrew Osborn and Natalia Zinets

MOSCOW/KIEV, July 18 (Reuters) - The pro-Russian rebel leader of a breakaway region in eastern Ukraine announced proposals to abolish Ukraine and create a new state in its place on Tuesday, comments that could further undermine a 2015 peace deal that is already faltering.

Ukrainian President Petro Poroshenko dismissed the idea, describing Alexander Zakharchenko, leader of the self-proclaimed Donetsk People's Republic (DNR), as part of "a puppet show", with Russia pulling his strings in order to relay a message.

Ukrainian officials said Russia wanted to show the world, and the United States especially, it could keep the crisis in a suspended state and deepen it if need be. A new U.S. envoy for the Ukraine crisis was appointed this month and Moscow and Washington are likely to start regularly engaging on the issue.

Zakharchenko, who scarcely would have expected anything other than outright rejection from Kiev, said in a declaration that he and his allies were proposing a new state called Malorossiya (Little Russia) be set up with its capital in rebel-held Donetsk.

Malorossiya was the term used to describe swaths of modern-day Ukraine when they were part of the Russian Empire and is one which many Ukrainians today regard as offensive.

"We are proposing to residents of Ukraine a peaceful way out of a difficult situation without war. It's our last proposal," Zakharchenko said in a statement. The new state would be federal, with regions enjoying a large degree of autonomy.

He said the move was backed by delegates from different Ukrainian regions, though a statement from the neighbouring rebel territory of the self-proclaimed Luhansk People's Republic said it had been unaware of the initiative.

"SICK FANTASIES"

His declaration cast a shadow over the faltering Minsk peace agreement between the rebels and the Ukrainian government which has failed to quell fighting between the two sides and has only been partially implemented since a pro-Russian uprising broke out in eastern Ukraine in 2014.

Russia denies accusations it has delivered arms and provided troops backing rebels in the industrial, largely Russian-speaking east.

Yevhen Marchuk, Ukraine's representative in talks on implementing the peace deal, told Ukrainian TV channel 112.ua that Zakharchenko's declaration would complicate negotiations and looked like a Russian attempt to sabotage the process.

France, which along with Germany has been closely involved in trying to resolve the Ukraine crisis, condemned the idea and demanded Russia do more to prevent a further escalation.