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A man walks past a Chinese national flag and a banner covering the entrance to a Japanese restaurant in Suzhou, Jiangsu province, September 17, 2012. Major Japanese firms have shut factories in China and urged expatriate workers on Monday to stay indoors ahead of what could be more angry protests over a territorial dispute that threatens to hurt trade ties between Asia's two biggest economies.

ALY SONG/Reuters

Some 1,000 Chinese fishing boats – draped in national flags – are reportedly en route to the waters around a disputed set of islands, posing a fresh challenge to the Japanese government's de facto sovereignty over the area and potentially bringing the Asian neighbours closer to conflict.

According to state-run media in China, the fishing boats are expected to reach the rich fishing grounds around the islands known as Senkaku in Japan and Diaoyu in China sometime Monday. The official People's Daily reported on its website that the country's coast guard equivalent, Chinese Marine Surveillance, would also conduct "patrol and law enforcement" activities in the disputed waters.

Tokyo faces a dilemma about how to respond. While the government has said it wants to avoid a military confrontation with China, a Japanese newspaper on Monday quoted an aide to Prime Minister Yoshihiko Noda warning that the showdown over the islands could enter "a new stage" if the fishing boats did approach the islands.

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"The government is taking a wait-and-see approach for the moment. But we will not be able to sit by idly if fishing vessels reach the Senkaku Islands in large numbers," the unnamed aide was quoted as saying by the Asahi Shimbun. He said the Japanese Coast Guard would be forced to make arrests if the fishing boats entered the waters Japan claims as its own, and that the navy would be on standby in case anything got out of control.

Either move would surely infuriate Beijing, which has repeatedly blamed Tokyo for instigating the crisis. "We once again demand the Japanese side to immediately stop all acts that infringe upon China's territorial sovereignty and return to the track of negotiations for the settlement of the controversial issues," Foreign Ministry spokesman Hong Lei said Monday.

But talks of any kind seem a long way off. China instead seems intent on forcing Mr. Noda's government to back down on its terms, while Japan – which has controlled the islands since 1895 except for a period of U.S. occupation following the Second World War – refuses to acknowledge there's even a territorial dispute to discuss.

The leadership in both countries has little room to find a compromise. Mr. Noda is facing a likely election in the coming months, one in which he will have to fend off a challenge from the nationalist right. Meanwhile, China's ruling Communist Party is on the verge of a once-a-decade transfer of power that will see President Hu Jintao and Premier Wen Jiabao make way for a new generation of leaders who are anxious to win the support of hawkish generals in the People's Liberation Army.

The decades-old argument over the uninhabited archipelago sharply escalated last week after Mr. Noda's government purchased three of the five islets from the Japanese family that had privately owned them since the 1970s. China responded to the sale by declaring new sea borders around the islands and then dispatching patrol ships to enforce them.

The confrontation between the world's second and third-largest economies is already affecting trade ties. Flagship Japanese companies such as Toyota, Nissan, Honda, Mazda, Panasonic, Canon and clothing retailer Uniqlo have all announced they will shutter their factories and stores in China for at least the next two days amid violent anti-Japanese protests that have seen Japanese businesses and cars attacked by angry mobs. There have been calls in China for a nationwide boycott of Japanese products.

Any kind of trade war between the world's second and third-largest economies would be devastating. Commerce between the two countries amounted to more than $340-billion last year, with many flagship Japanese brands doing much of their production in China.

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Neither side can afford for that to disappear – the Japanese economy grew just 1.4 per cent in the second quarter of 2012, while China posted 7.6 per cent growth, its slowest pace in three years.

United States Defense Secretary Leon Panetta, who has warned that the confrontation has the potential to start a regional war, on Tuesday urged both sides to exercise restraint.

"It is in everybody's interest for Japan and China to maintain good relations and to find a way to avoid further escalation," he told a news conference in Tokyo after meetings with the Japanese foreign and defence ministers. During the visit, Mr. Panetta announced that the U.S. would locate a new missile defence radar on Japanese territory, a move the U.S. and Japan say is a response to the growing threat from North Korea, but which will nonetheless be interpreted as hostile by China.

Mr. Panetta's next stop is Beijing, where he will meet Defense Minister Liang Guanglie and Vice-President Xi Jinping, who is set to takeover as China's paramount leader in the months ahead.

Anti-Japanese protests involving tens of thousands of people have broken out in dozens of Chinese cities over the past week. Demonstrators besieged the Japanese Embassy in Beijing for a seventh straight day on Monday, with some calling for their government to declare war over the island dispute. Violent protests have also erupted in Guangzhou, Shenzhen, Qingdao and dozens of other cities.

Chinese authorities, usually quick to stamp out any hint of social unrest, have facilitated the protests by closing roads around the Japanese Embassy and allowing demonstrators to hurl bottles and eggs at its front gate.

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The protests are expected to worsen Tuesday, which marks the anniversary of the 1931 Mukden Incident, a staged attack on a Japanese railroad that was used to justify the Japanese Imperial Army's invasion and occupation of Manchuria at the outset of the Second World War.

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