diff --git a/compiler/frontend/src/org/jetbrains/jet/lang/cfg/JetControlFlowProcessor.java b/compiler/frontend/src/org/jetbrains/jet/lang/cfg/JetControlFlowProcessor.java
index 96a4d1adecc..11306ec0a52 100644
--- a/compiler/frontend/src/org/jetbrains/jet/lang/cfg/JetControlFlowProcessor.java
+++ b/compiler/frontend/src/org/jetbrains/jet/lang/cfg/JetControlFlowProcessor.java
@@ -916,16 +916,6 @@ public class JetControlFlowProcessor {
             JetObjectDeclaration declaration = expression.getObjectDeclaration();
             generateInstructions(declaration, context);
 
-            List<JetDeclaration> declarations = declaration.getDeclarations();
-            List<JetDeclaration> functions = Lists.newArrayList();
-            for (JetDeclaration localDeclaration : declarations) {
-                if (!(localDeclaration instanceof JetProperty) && !(localDeclaration instanceof JetClassInitializer)) {
-                    functions.add(localDeclaration);
-                }
-            }
-            for (JetDeclaration function : functions) {
-                generateInstructions(function, context);
-            }
             builder.createAnonymousObject(expression);
         }
 
@@ -961,6 +951,13 @@ public class JetControlFlowProcessor {
                 generateInstructions(specifier, context);
             }
             List<JetDeclaration> declarations = classOrObject.getDeclarations();
+            if (JetPsiUtil.isLocal(classOrObject)) {
+                for (JetDeclaration declaration : declarations) {
+                    generateInstructions(declaration, context);
+                }
+                return;
+            }
+            //For top-level and inner classes and objects functions are collected and checked separately.
             for (JetDeclaration declaration : declarations) {
                 if (declaration instanceof JetProperty || declaration instanceof JetClassInitializer) {
                     generateInstructions(declaration, context);
diff --git a/compiler/testData/cfg/localClass.instructions b/compiler/testData/cfg/localClass.instructions
new file mode 100644
index 00000000000..394341737f9
--- /dev/null
+++ b/compiler/testData/cfg/localClass.instructions
@@ -0,0 +1,113 @@
+== f ==
+fun f() {
+    class LocalClass() {
+        fun f() {
+            val x = ""
+
+            fun loc() {
+                val x3 = ""
+            }
+        }
+    }
+}
+---------------------
+L0:
+    <START>
+    mark({ class LocalClass() { fun f() { val x = "" fun loc() { val x3 = "" } } } })
+    jmp?(L2)                                                                             NEXT:[<END>, d(fun f() { val x = "" fun loc() { val x3 = "" } })]
+    d(fun f() { val x = "" fun loc() { val x3 = "" } })                                  NEXT:[<SINK>]
+L1:
+L2:
+    <END>                                                                                NEXT:[<SINK>]                                                                               PREV:[jmp?(L2)]
+error:
+    <ERROR>                                                                              PREV:[]
+sink:
+    <SINK>                                                                               PREV:[<ERROR>, <END>, d(fun f() { val x = "" fun loc() { val x3 = "" } })]
+L3:
+    <START>
+    mark({ val x = "" fun loc() { val x3 = "" } })
+    v(val x = "")
+    mark("")
+    r("")
+    w(x)
+    jmp?(L5)                                          NEXT:[<END>, d(fun loc() { val x3 = "" })]
+    d(fun loc() { val x3 = "" })                      NEXT:[<SINK>]
+L4:
+L5:
+    <END>                                             NEXT:[<SINK>]                                            PREV:[jmp?(L5)]
+error:
+    <ERROR>                                           PREV:[]
+sink:
+    <SINK>                                            PREV:[<ERROR>, <END>, d(fun loc() { val x3 = "" })]
+L6:
+    <START>
+    mark({ val x3 = "" })
+    v(val x3 = "")
+    mark("")
+    r("")
+    w(x3)
+L7:
+    <END>                    NEXT:[<SINK>]
+error:
+    <ERROR>                  PREV:[]
+sink:
+    <SINK>                   PREV:[<ERROR>, <END>]
+=====================
+== f ==
+fun f() {
+            val x = ""
+
+            fun loc() {
+                val x3 = ""
+            }
+        }
+---------------------
+L3:
+    <START>
+    mark({ val x = "" fun loc() { val x3 = "" } })
+    v(val x = "")
+    mark("")
+    r("")
+    w(x)
+    jmp?(L5)                                          NEXT:[<END>, d(fun loc() { val x3 = "" })]
+    d(fun loc() { val x3 = "" })                      NEXT:[<SINK>]
+L4:
+L5:
+    <END>                                             NEXT:[<SINK>]                                            PREV:[jmp?(L5)]
+error:
+    <ERROR>                                           PREV:[]
+sink:
+    <SINK>                                            PREV:[<ERROR>, <END>, d(fun loc() { val x3 = "" })]
+L6:
+    <START>
+    mark({ val x3 = "" })
+    v(val x3 = "")
+    mark("")
+    r("")
+    w(x3)
+L7:
+    <END>                    NEXT:[<SINK>]
+error:
+    <ERROR>                  PREV:[]
+sink:
+    <SINK>                   PREV:[<ERROR>, <END>]
+=====================
+== loc ==
+fun loc() {
+                val x3 = ""
+            }
+---------------------
+L6:
+    <START>
+    mark({ val x3 = "" })
+    v(val x3 = "")
+    mark("")
+    r("")
+    w(x3)
+L7:
+    <END>                    NEXT:[<SINK>]
+error:
+    <ERROR>                  PREV:[]
+sink:
+    <SINK>                   PREV:[<ERROR>, <END>]
+=====================
diff --git a/compiler/testData/cfg/localClass.kt b/compiler/testData/cfg/localClass.kt
new file mode 100644
index 00000000000..f68a2ac125c
--- /dev/null
+++ b/compiler/testData/cfg/localClass.kt
@@ -0,0 +1,11 @@
+fun f() {
+    class LocalClass() {
+        fun f() {
+            val x = ""
+
+            fun loc() {
+                val x3 = ""
+            }
+        }
+    }
+}
\ No newline at end of file
diff --git a/compiler/testData/diagnostics/tests/controlFlowAnalysis/kt3501.kt b/compiler/testData/diagnostics/tests/controlFlowAnalysis/kt3501.kt
new file mode 100644
index 00000000000..bb9731dc3a4
--- /dev/null
+++ b/compiler/testData/diagnostics/tests/controlFlowAnalysis/kt3501.kt
@@ -0,0 +1,9 @@
+//KT-3501 Variable/parameter is highlighted as unused if it is used in member of local class
+
+fun f(p: String) { // "p" is marked as unused
+    class LocalClass {
+        fun f() {
+            <!UNUSED_EXPRESSION!>p<!>
+        }
+    }
+}
\ No newline at end of file
diff --git a/compiler/testData/diagnostics/tests/controlFlowAnalysis/localClasses.kt b/compiler/testData/diagnostics/tests/controlFlowAnalysis/localClasses.kt
new file mode 100644
index 00000000000..6c3890bcd69
--- /dev/null
+++ b/compiler/testData/diagnostics/tests/controlFlowAnalysis/localClasses.kt
@@ -0,0 +1,26 @@
+package f
+
+fun f() {
+    class LocalClass() {
+        {
+            val <!UNUSED_VARIABLE!>x1<!> = "" // ok: unused
+
+            fun loc1(): Int {
+                val <!UNUSED_VARIABLE!>x1_<!> = "" // ok: unused
+            <!NO_RETURN_IN_FUNCTION_WITH_BLOCK_BODY!>}<!>
+        }
+
+        fun f() {
+            val <!UNUSED_VARIABLE!>x2<!> = "" // error: should be UNUSED_VARIABLE
+
+            fun loc2(): Int {
+                val <!UNUSED_VARIABLE!>x2_<!> = "" // error: should be UNUSED_VARIABLE
+            <!NO_RETURN_IN_FUNCTION_WITH_BLOCK_BODY, NO_RETURN_IN_FUNCTION_WITH_BLOCK_BODY!>}<!>
+        }
+
+        val v: String
+            get() {
+                val <!UNUSED_VARIABLE!>x3<!> = "" // ok: unused
+            <!NO_RETURN_IN_FUNCTION_WITH_BLOCK_BODY!>}<!>
+    }
+}
diff --git a/compiler/testData/diagnostics/tests/inner/referenceToSelfInLocal.kt b/compiler/testData/diagnostics/tests/inner/referenceToSelfInLocal.kt
index e49bfee8248..1b8965f90a5 100644
--- a/compiler/testData/diagnostics/tests/inner/referenceToSelfInLocal.kt
+++ b/compiler/testData/diagnostics/tests/inner/referenceToSelfInLocal.kt
@@ -7,7 +7,7 @@ fun f() {
         }
 
         fun member() {
-            val x: MyClass = MyClass()
+            val <!UNUSED_VARIABLE!>x<!>: MyClass = MyClass()
         }
     }
 
diff --git a/compiler/tests/org/jetbrains/jet/cfg/ControlFlowTestGenerated.java b/compiler/tests/org/jetbrains/jet/cfg/ControlFlowTestGenerated.java
index dfd86729115..bc5fd592ad9 100644
--- a/compiler/tests/org/jetbrains/jet/cfg/ControlFlowTestGenerated.java
+++ b/compiler/tests/org/jetbrains/jet/cfg/ControlFlowTestGenerated.java
@@ -157,6 +157,11 @@ public class ControlFlowTestGenerated extends AbstractControlFlowTest {
         doTest("compiler/testData/cfg/LazyBooleans.kt");
     }
     
+    @TestMetadata("localClass.kt")
+    public void testLocalClass() throws Exception {
+        doTest("compiler/testData/cfg/localClass.kt");
+    }
+    
     @TestMetadata("LocalDeclarations.kt")
     public void testLocalDeclarations() throws Exception {
         doTest("compiler/testData/cfg/LocalDeclarations.kt");
diff --git a/compiler/tests/org/jetbrains/jet/checkers/JetDiagnosticsTestGenerated.java b/compiler/tests/org/jetbrains/jet/checkers/JetDiagnosticsTestGenerated.java
index 7f6ff10850d..19c9c44656f 100644
--- a/compiler/tests/org/jetbrains/jet/checkers/JetDiagnosticsTestGenerated.java
+++ b/compiler/tests/org/jetbrains/jet/checkers/JetDiagnosticsTestGenerated.java
@@ -1608,6 +1608,11 @@ public class JetDiagnosticsTestGenerated extends AbstractJetDiagnosticsTest {
                 doTest("compiler/testData/diagnostics/tests/controlFlowAnalysis/kt3444.kt");
             }
             
+            @TestMetadata("kt3501.kt")
+            public void testKt3501() throws Exception {
+                doTest("compiler/testData/diagnostics/tests/controlFlowAnalysis/kt3501.kt");
+            }
+            
             @TestMetadata("kt510.kt")
             public void testKt510() throws Exception {
                 doTest("compiler/testData/diagnostics/tests/controlFlowAnalysis/kt510.kt");
@@ -1643,6 +1648,11 @@ public class JetDiagnosticsTestGenerated extends AbstractJetDiagnosticsTest {
                 doTest("compiler/testData/diagnostics/tests/controlFlowAnalysis/kt897.kt");
             }
             
+            @TestMetadata("localClasses.kt")
+            public void testLocalClasses() throws Exception {
+                doTest("compiler/testData/diagnostics/tests/controlFlowAnalysis/localClasses.kt");
+            }
+            
             @TestMetadata("propertiesOrderInPackage.kt")
             public void testPropertiesOrderInPackage() throws Exception {
                 doTest("compiler/testData/diagnostics/tests/controlFlowAnalysis/propertiesOrderInPackage.kt");
diff --git a/idea/testData/checker/infos/CapturedInInlinedClosure.kt b/idea/testData/checker/infos/CapturedInInlinedClosure.kt
index 558b3446c9a..40f7c432d11 100644
--- a/idea/testData/checker/infos/CapturedInInlinedClosure.kt
+++ b/idea/testData/checker/infos/CapturedInInlinedClosure.kt
@@ -58,7 +58,7 @@ fun localFunctionAndClass() {
         }
     }
 
-    val <info descr="Value captured in a closure"><warning>v</warning></info> = 1 // erroneous "unused warning" is caused by KT-3501
+    val <info descr="Value captured in a closure">v</info> = 1
     class LocalClass {
         fun f() {
             run {