PayPal’s not just for buying Pez dispensers on eBay any more. The popular Internet payment service is quickly becoming the currency of choice at many online casinos.

Nearly 500 gambling sites signed up to accept PayPal in the first quarter this year, almost doubling the company’s roster of such merchants, which stood at 1,022 as of March 31, according to PayPal.

Unfortunately for PayPal, its booming online gambling business may be illegal in the United States.

“If you help to facilitate or promote gambling, you could be found guilty of breaking the law. We’re trying to get the message out to intermediaries that there’s real liability there,” said Ken Dreifach, head of the Internet bureau at New York State’s office of the attorney general. New York estimates that offshore online gambling sites soak Americans for $4 billion annually.

While efforts to pass federal laws specifically prohibiting online gambling have stalled, New York’s saber rattling impressed Citibank. The nation’s biggest credit card issuer announced earlier this month that it has agreed to ban the use of its credit cards for Internet gaming. In doing so, Citibank belatedly joined Bank of America, Fleet, MBNA, Chase Manhattan and several other major banks that have established policies forbidding their credit card holders from placing online bets.

Now, in their quest to protect citizens from the “pernicious” effects of online gambling, New York and other state and federal regulators are also turning their attention to non-bank financial services such as PayPal, according to Dreifach.

PayPal officials declined comment on the company’s role in online gambling, citing a mandated quiet period in the run-up to its impending secondary stock offering. But documents filed with the Securities and Exchange Commission reveal that PayPal is well aware of the dangers of servicing gaming sites, which it terms “higher risk” accounts.

PayPal’s latest IPO filing acknowledges that its business with online casinos could be jeopardized by their “uncertain” legal status, and could expose it to “civil and criminal lawsuits, administrative action, and prosecution for, among other things, money laundering or for aiding and abetting violations of law.”

In exchange …