Announcement of the leaders' discussion added weight to market talk of the merger, which would be the largest ever seen and would create a new telecommunications giant worth more than $200 billion.

The report that the two companies were in talks first surfaced in European newspapers on Friday but was initially seen as improbable because of the huge political and regulatory hurdles involved.

But with European markets already closed for the weekend, D'Alema's office confirmed that he and Schroeder "in the course of their conversation...examined questions relating to a possible accord between Telecom Italia and Deutsche Telekom."

And banking sources told Reuters Telecom Italia chief Franco Bernabe had been holding talks with a number of parties in an effort to thwart a hostiletakeover bid by Olivetti SpA.

"Bernabe is in a hurry to do something. He is in the driving seat on this. All information is centralised with one person who is not predictable and is keeping his cards very close to his chest," one first investment banker added.

Another suggested that the merger between the two telecom giants could even be announced over the weekend. Considerable regulatory and political hurdles would need to be overcome in order to wrap up a deal between the two companies.

But banking sources pointed out that the Italian government had allowed Olivetti to make its bid for Telecom Italia and would thus find it hard to stand in Deutsche Telekom's way.

Olivetti swooped on Telecom Italia in February with a 10 euros per share cash, share and bond offer, later increased to 11.50 euros per share. Telecom has fought off the unwanted bid but its defence strategy has failed to impress shareholders.

To add further complexity, the German newspaper Die Welt reported in an unsourced storyreleased ahead of publication in Saturday's issue that Deutsche Telekom was in advanced talks to buy Britain's Cable & Wireless Plc.

Both companies declined comment on the story, which analysts saw as less likely than the Telecom Italia tie-up, but options volume in C&W jumped in Chicago in reaction.

Before the D'Alema-Schroeder talks, most telecom analysts had reacted with scepticism or outright disbelief to the German-Italian merger report.

"No, I don't believe it can happen," said Jonathan Shantry at Credit Lyonnais in London. "There are too many regulatory hurdles. The Italian government wouldn't be happy. It doesn't fit in with Deutsche Telekom's strategy."

The stock market apparently confirmed that view, as neither firm's shares attracted extraordinary interest.

Deutsche Telekom shares closed up five cents at 38.15 euros after falling nearly eight percent on Thursday on news of a capital increase.

Telecom Italia finished three percent higher at 9.88 euros, still below the 11.50 euros pershare Olivetti has offered.

"Telecom Italia shares are not rising more because the market is treating this report as newspaper talk. Deutsche Telekom is just another name that has popped up," said Cabato analyst Deirdre Ernest in Milan. "If the market really believed it, Telecom Italia shares would be way up," Shantry said.

The Financial Times said in its Friday report that the groups were in advanced talks that had been brought to a head in February by Olivetti's $65 billion bid for Telecom Italia, Europe's fourth-largest carrier. Milan daily Il Giornale said the companies planned to give Deutsche Telekom control of their fixed-line operations, and turn their mobile phone businesses over to Telecom Italia Mobile, in which Telecom Italia holds a majority.

The market's doubt stems from the huge regulatory, political and corporate problems any merger of the two former monopoly phone companies would face.

Any agreement would be complicated since the German government owns 74 percent ofDeutsche Telekom. The Italian government has 3.4 percent of its national carrier and has the power to block a takeover by a foreign company.

European Union sources said its competition watchdog would "look very closely" at a merger of the two former monopolies. "The hurdles are very high," said Holger Grawe, an analyst at WestLB Panmure. "The governments would have to agree, the Brussels and German regulators would have to agree."