By Doug Palmer

WASHINGTON (Reuters) - A record drop in U.S. imports because of slowing domestic demand took a big bite out of the U.S. trade deficit in March despite record high oil prices.

The trade gap shrank 5.7 percent in March to $58.2 billion, the Commerce Department reported on Friday, much smaller than expected. The decline reflected another strong month of U.S. exports and a record $6.1 billion drop in imports to $206.7 billion, which showed the U.S. slowdown has taken a toll on consumer and business demand for foreign goods.

"Trade continues to be a huge support for the U.S. economy. Export demand is holding up well," said Nigel Gault, chief U.S. economist at Global Insight. "Meanwhile, much of the slowdown in U.S. domestic spending is being passed on to the rest of the world through lower imports."

The narrowing trade gap means the U.S. economic growth was somewhat stronger than first estimated. Based on the trade data, Gault said he expected the government to raise its estimate of first quarter U.S. economic growth to 0.9 percent, from an initial reading of 0.6 percent last month.

Ian Shepherdson, chief U.S. economist with High Frequency Economics, pegged first quarter growth at 1.1 percent because of a stronger-than-expected contribution from trade.

U.S. Commerce Secretary Carlos Gutierrez said the March data showed a "very strong close to the quarter."

Compared with first quarter 2007, U.S. exports are up 17.6 percent, while imports have increased 12 percent, he said.

The economy is still not performing as well as it could, but Congress should wait to see the results of a recent $152 billion economic stimulus package before passing new legislation, he told Reuters.

"Obviously, we're looking at data every single day and talking about this every single day, but let's see how this works," Gutierrez said.

RECORD OIL PRICES, REDUCED OIL IMPORTS

U.S. markets paid little attention to report, focusing instead on renewed concerns about the financial services sector after American International Group <AIG.N>, the world's largest insurer, posted a record $7.8 billion quarterly loss.

The Dow Jones industrial average was down more that 1 percent. The dollar was lower, but U.S. government debt prices rose.

Average oil prices jumped more than $5 per barrel in March to a record $89.85, compared to $53.00 in the same month last year. As prices have move skyward, the volume of oil imports fell in March to 8.99 million barrels a day - the lowest since February 2003 and well below the 2007 average of 10.1 million.

U.S. exports retreated slightly in March, but were still the second highest on record at $148.5 billion. Although exports of U.S. aircraft, autos, and consumer goods all fell in March, overall shipments to the European Union and South and Central America set records during the month.

Before the March decline, U.S. exports had set records in 12 consecutive months - helping to keep the U.S. economy afloat during a time of turmoil brought on by a housing slump and spreading liquidity crisis.

"In general, the narrowing trade gap has reflected a rise in exports, helped by a weaker dollar and higher demand outside of the U.S.," said James O'Sullivan, economist with UBS Securities LLC in Stamford, Connecticut.

The closely-watched U.S. trade deficit with China narrowed to $16.1 billion in March, the lowest in two years. U.S. exports to China jumped 10 percent to their second highest on record, while imports from that country fell 7 percent.

(Additional reporting by Richard Leong in New York; Editing by Neil Stempleman)