By Tom Balmforth and Pavel Polityuk
KYIV (Reuters) -Ukrainian forces reached the entrance of the eastern bastion of Lyman on Saturday after encircling thousands of Russian troops, Kyiv said, in a battlefield rebuttal to the Kremlin a day after it proclaimed a swathe of territory to be part of Russia.
The capture of Lyman would be a major setback for Russia after President Vladimir Putin proclaimed the annexation of the Donetsk region, along with three other regions, at a ceremony in Moscow on Friday condemned by Kyiv and the West as a farce.
Two grinning Ukrainian soldiers taped the yellow-and-blue national flag onto the "Lyman" welcome board at the entrance to the town in the north of Donetsk region, a video posted by the president's chief of staff showed.
"Oct. 1. We are unfurling our state flag and establishing it on our land. Lyman will be Ukraine," one of the soldiers said, standing on the bonnet of a military vehice.
A spokesperson for Ukraine's eastern forces said Russia had 5,000 to 5,500 troops at Lyman but that the number of encircled troops could be lower because of casualties.
"The Russian grouping in the area of Lyman is surrounded," the spokeperson, Serhii Cherevatyi, said on television.
The Russian Defence Ministry did not immediately respond to a request for comment.
Russia's last operational update was on Friday evening. On Saturday, the ministry's Telegram channel published a series of congratulatory messages, including one from Putin, to mark an army holiday, Ground Forces Day.
Russia has used Lyman as a logistics and transport hub for its operations in the north of the Donetsk region. Its fall would be Ukraine's biggest battlefield gain since a lightning counteroffensive in the northeastern Kharkiv region last month.
The Ukrainian military spokersperson said the capture of Lyman would allow Kyiv to advance into the Luhansk region, whose full capture Moscow announced at the beginning of July after weeks of slow, grinding advances.
"Lyman is important because it is the next step towards the liberation of the Ukrainian Donbas. It is an opportunity to go further to Kreminna and Sievierodonetsk, and it is psychologically very important," he said.
Donetsk and Luhansk regions together make up the wider Donbas region that has been a major focus for Russia since soon after the start of Moscow's invasion on Feb. 24.
Cherevatyi said the operation around Lyman is still under way and Russian troops are mounting unsuccessful attempts to break out of the encirclement.
"Some are surrendering, they have a lot of killed and wounded, but the operation is not yet over," he said.
Ukraine's exiled governor of Luhansk said Russian forces had asked for a safe exit out of the encirclement, but Ukraine rejected the request.
The Ukrainian General Staff told Reuters it had no such information.
Putin proclaimed the Donbas regions of Donetsk and Luhansk and the southern regions of Kherson and Zaporizhzhia to be Russian land in Friday's ceremony - a swathe of territory equal to about 18% of Ukraine's total surface land area.
Ukraine and its Western allies branded Russia's move as illegal. Kyiv vowed to continue liberating its land of Russian forces and said it would not hold peace talks with Moscow while Putin remained as president.
(Editing by Frances Kerry and Gareth Jones)