Even by the standards of Washington politics it was an unusual spectacle - the veiled leader of a Middle East group banned in the US as a terrorist organisation delivering a speech by live video-link to applauding members of Congress inside the Capitol itself.

But since the organisation is dedicated to the overthrow of Iran's theocracy, the People's Mujahideen Organisation and its political co-leader, Maryam Rajavi, are given leeway in the US as they campaign to have the "terrorist" tag removed and to become eligible for US funding of Iranian opposition groups.

In suit and matching headscarf, Mrs Rajavi spoke from France. She thanked six congressmen by name for their support, praised President George W. Bush and called for an end to western "appeasement" of the "engine of Islamic fundamentalism".

The audience - a mix of Iranian-Americans, politicians and staffers filling a conference room in the Capitol last Thursday - gave her a standing ovation. Sheila Jackson Lee, a Democrat congresswoman from Texas, spoke warmly of "sister Maryam".

Known by its acronyms MKO and MEK, the group led by Mrs Rajavi and her husband Massoud, was outlawed by the US for its killing of Americans before the 1979 Iranian revolution; alleged collaboration with Saddam Hussein's genocidal campaigns against Iraqi Kurds; and attacks on civilians inside Iran.

The MKO denies the charges of terrorism, saying it was banned by then-president Bill Clinton in an attempt to engage the Iranian government.

Despite its attraction to the US - and particularly to some Pentagon planners - as an armed force inside Iraq ready in opposition, analysts in Washington doubt the group will regain legitimacy.

Nonetheless, its lobbying reflects the ferment inside the Bush administration as it grapples with producing a coherent policy towards Iran, working out - in the words of one European diplomat - whether to "engage, isolate or disrupt".

Stephen Hadley, national security adviser, commissioned 10 briefing papers exploring various options. A National Security Council meeting was cancelled this month after one of the papers, which proposed expanding diplomatic contacts with Iran, was leaked to the Wall Street Journal. Some officials suspect that someone senior wanted to sabotage the idea.

Diplomats and two US officials said the latest review was prompted by the conclusion reached by Condoleezza Rice, secretary of state, and others that an effective sanctions option did not exist, and that they had been misled by the predictions of neoconservatives who saw the Iranian regime ripe for overthrow by a restless populace.

Recent statements by Ms Rice point to an effort to broaden diplomatic contacts with Iran.

Diplomats also say there is a new effort to find a settlement, negotiated through European allies, to the standoff over Iran's nuclear programme. But officials say any such pragmatic tendencies would be tempered by the conviction that the Bush administration should do nothing that would be seen to confer legitimacy on the regime while actively supporting the democratic aspirations of Iranians.

Iranian-American sympathisers of the MKO, who are active donors to US politicians, remain hopeful their group will be de-listed.