UPDATE 6-Oil down on high U.S. fuel stocks, firm dollar

* EIA: U.S. fuel stocks rise, crude supplies fall

* U.S. tax cut extension plan edges forward

* China interest rates, OPEC meeting in focus

* Coming Up: U.S. jobless claims data on Thursday (Recasts, updates prices, market activity to settlement)

By Gene Ramos

NEW YORK, Dec 8 (Reuters) - Oil prices dipped for a second day on Wednesday, as unexpectedly large increases in U.S. fuel inventories and a stronger dollar sparked selling in crude, one day after it hit a 26-month high.

A tax cut extension deal between U.S. President Barack Obama and Republicans that could bolster consumer spending and boost energy demand helped limit the crude's losses, as did wintry weather in much of the United States.

U.S. crude for January delivery settled 41 cents lower at $88.28 a barrel, well off Tuesday's session high of $90.76, the highest since October, 2008.

Trading was brisk, with volume hitting 676,200 lots as of 3:05 p.m. EST (2005 GMT), surpassing the 30-day average of 652,133.

Prices have fallen from the two-year high, which exceeded the $90 mark that Saudi Arabian Oil Minister Ali al-Naimi said on Nov. 1 was a level consumers could tolerate.

Naimi and other oil ministers of the Organization of Petroleum Exporting Countries, source of more than a third of the world's oil, meet on Dec. 11 in Quito, Ecuador. The group is not expected to change its production policy.

In London, ICE January Brent dropped 62 cents to settle at $90.77 a barrel.

U.S. gasoline stockpiles rose by a more-than-expected 3.8 million barrels last week, the Energy Information Administration's inventory data showed.

Stocks of distillates, which include heating oil and diesel fuel, rose 2.2 million barrels, dashing forecasts for a modest drawdown.

The fuel stocks increase overshadowed a drawdown of 3.8 million barrels in crude inventories, larger than expected, on the heels of a surprisingly big jump in refinery utilization.

"On the surface this is a bearish report showing lackluster demand with the increase in products," said Mike Zarembski of OptionsXpress in Chicago.

TAX CUT DEAL, DOLLAR MOVEMENT

Obama's plan to broadly extend tax cuts edged forward despite opposition from his own Democrats and fear in the bond markets of long-term damage to the economy.

Some see the plan as a needed stimulus to the shaky economy, but others fear the longer-term rise in U.S. debt.

The dollar trimmed gains against the yen and the euro as U.S. Treasury yields came off their highs following a $21 billion sale of 10-year notes. The dollar rose earlier as Treasury yields spiked in reaction to the likelihood of the tax cut plan going forward.

The dollar rose 0.2 percent against a basket of currencies, as money traders put euro zone debt concerns on the back burner, focusing instead on U.S. economic prospects.

Recent U.S. economic data on retail sales and growth in the service sector signaled economic recovery, although last week's data showing a jump to 9.8 percent in the unemployment rate has tempered the growth outlook.

A stronger dollar tends to weigh on the price of oil and other dollar-denominated commodities.

Analysts noted that from Tuesday, the oil price structure has normalized further after a dramatic switch on Friday and Monday to backwardation, in which crude deliveries in the near future have higher prices than those later on.

When prices are higher for the later months, the situation is called contango.

"The rapid reversal of structural contango positions has now given way to a more measured response to tighter market conditions," said Lawrence Eagles, analyst at J.P. Morgan in New York.

Oil's downward trend could persist if China proceeded with a speculated rise in interest rates to cool down its overheated economic growth.

"For the holiday period the main risk will come from China as the odds for an interest rate hike are increasing," said Olivier Jakob from Petromatrix. (Additional reporting by Robert Gibbons in New York, Dmitry Zhdannikov and Alex Lawler in London; Alejandro Barbajosa in Singapore; Editing by David Gregorio)