With two Iranian waiters drumming their fingers on the table, a group of Italian businessmen sang lusty love songs as restaurant patrons smiled, laughed and tapped their feet. The impromptu concert at a downtown Tehran restaurant reflected the current mood in Iran's relations with the European Union as the two sides embrace after years of strained relations.

"We are like old friends reuniting," one Western diplomat said. "Of course, there are still problems, but we are trying our best to work them out."

While Iran's raging power struggle between reformist supporters of President Mohammed Khatemi and his powerful conservative rivals captures headlines, a quiet revolution has been taking place in Iranian foreign policy as Tehran also improves its ties with the Arab world and consolidates its close ties to Japan, China and Southeast Asia.

Iran's ties with the European Union are of particular importance, Foreign Ministry officials said, because they signal most vividly the country's return to the international community after years of isolation.

A key member of the Organization of Petroleum Exporting Countries bounded by the strategic Persian Gulf and Caspian Sea, Iran possesses the world's fifth-largest oil reserves and the second-largest gas reserves.

Following the 1979 revolution, which resonated with anti-Western and anti-imperialist themes, Iran's diplomatic relations with most European states suffered. Relations began to improve at the end of the Iran-Iraq war in 1988 when the newly formed Supreme National Security Council adopted a pro-Europe foreign policy. However, the February 1989 death edict against British writer Salman Rushdie for blaspheming Islam in his book "The Satanic Verses" derailed the initiative. Iran began to back away from the fatwa against Rushdie last year.

Relations gradually improved throughout the 1990s, with Italy and France in the lead, but they hit another low point in early 1997 when a German court implicated Iranian officials in the assassination of Kurdish dissidents in Berlin. After the verdict, all European Union ambassadors in Tehran were withdrawn for nearly six months.

Today, the atmosphere has warmed considerably. Khatemi wooed France and Italy on recent visits and is planning a trip to Germany. Two European Union presidents, Thomas Klestil of Austria and Constantine Stephanopoulos of Greece, visited Iran recently, the first EU heads of state to visit since the revolution.

Iranian Foreign Minister Kamal Kharrazi is expected to visit London in January, to be followed by British Foreign Minister Robin Cook's visit to Iran in April.

Ties have improved so rapidly that some diplomats have been caught by surprise. At a recent meeting of a European ambassador and Iranian government officials, the ambassador was shocked to be sitting across the table from a senior Iranian general, usually off-limits to Western diplomats.

"We have come a long way," said a Western diplomat, who asked not to be named. "These days, we are witnessing substantial and serious moves on both sides to improve ties."

Western diplomats cited as a key consideration Iran's geopolitical and economic weight in the region. They said dialogue with Tehran helps prevent misunderstandings and leads to cooperation in such fields as anti-narcotics efforts and refugee assistance. It also could temper some of Iran's opposition to the Middle East peace process, diplomats said, although recent intelligence reports from Washington and Western Europe point to increased Iranian support for groups opposed to peace.

European oil companies have benefited from the warming ties, grabbing major contracts all over Iran, much to the dismay of their American rivals, who are shackled by U.S. economic sanctions imposed for Iran's support of terrorism. Last month, Royal Dutch/ Shell Group, the Anglo-Dutch oil and gas company, was awarded an $800 million contract to invest in two major offshore oil fields. TOTAL, the French state-owned oil firm, is leading two major oil and gas projects, worth more than $2.5 billion. A French-Italian joint venture is running another $850 million project.

And it's not only oil. Every day, European businessmen arrive in Tehran on flights from Lufthansa, Swissair, and British Airways eager to cut deals, sell products, and seek out investment opportunities.

"Iran has adopted a pro-Europe commercial policy," said Bijan Khajehpour, a leading Tehran-based business consultant. "In the absence of American competition, the field is open to many European companies." Europe has responded warmly to Iran's welcome. European trade delegations have flooded the capital in recent months.

"Wherever you turn in Iran, there are business opportunities," said Bob Fisher, the head of a British trade delegation to Iran last month.

Iran maintained steady, albeit limited, commercial ties with several European states throughout the years of tension. Italy and France emerged as key commercial partners after the Rushdie affair, cutting into Germany's once dominant share of the market.

While Europe may be smiling, Iran is not wholly satisfied. "It is clear that Iran would prefer to have American private sector participation in the country's economy," Khajehpour noted, adding that years of European commercial contacts transformed Iran's once American-dominated industrial and infrastructure base to a primarily European one now.

Meanwhile, back at the restaurant, the crooning Italian businessmen frowned at the prospect of an American return to Iran. "Tell the Americans they should stay away from Iran," one of the businessman said. "It is really terrible here."