German Chancellor Angela Merkel told British Prime Minister Boris Johnson on Tuesday that his Brexit plan was doomed to fail without further compromise on the Irish border issue, a Downing Street source said.
"Merkel said that if Germany wanted to leave the EU they could do it no problem but the United Kingdom cannot leave without leaving Northern Ireland behind in a customs union and in full alignment for ever", said the source.
Reports from the BBC and Sky said Boris Johnson, the Prime Minister, claimed the demand meant a deal was "essentially impossible".
The German government confirmed that Ms Merkel and Mr Johnson had spoken but declined to comment on the substance of "confidential conversations".
The No 10 source suggested Mrs Merkel told her counterpart the only way to break the deadlock was for Northern Ireland to stay in the customs union and for it to permanently accept EU single market rules on trade in goods.
In Belfast, Arlene Foster, leader of the Democratic Unionist Party, described a suggestion that Northern Ireland would be kept in the EU Customs Union as beyond insane.
After presenting the plans, government sources hoped the United Kingdom might be able to enter an intense 10-day period of negotiations nearly immediately, with the aim of coming to a final agreement at an European Union summit on 17 October.
In what would be the first Saturday sitting since 1982, when Argentina invaded the Falklands Islands, and only the third since World War II, MPs will be recalled even if there is no Brexit deal to vote on.
Johnson has promised to deliver Brexit by the end of the month and the only way that this will be possible (or so it appears) is if Britain goes out with no deal, because as we know parliament is deeply divided.
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Jane Foley, a senior foreign exchange strategist at Rabobank, said the market remains highly sensitive to Brexit news and so rhetoric from key players in the Brexit decision-making process could have an impact.
While the Irish Government and the European Union were working to get an agreement, he said they were not prepared to do a deal "at any cost".
The host of next week's European summit, EU Council President Donald Tusk, on Tuesday accused Prime Minister Boris Johnson of trying to shift blame for the failure of Brexit talks.
He said: "In my mind it is completely improbable that the phone call between Merkel and Johnson took place in the way it has been reported in the British media. Additionally, they're not immediately operable", he included in Tuesday evening's announcement.
He told the French Les Echos newspaper that in such an event, both sides would suffer. But, under the Benn Act, he also is required to seek an extension if he doesn't have a deal by October 19 - something that may still force him to seek a delay and hold a general election before going back to Brussels again.
A Downing Street source said: "The call with Merkel showed the European Union has adopted a new position".
The news comes following the publication of a leaked government source which claims that Johnson will do "all sorts of things" to prevent a further delay to Brexit.
"The last trading weeks have been one big highlight of how fragile the rally in the pound was over August and September", said Lars Merklin, a strategist at Danske Bank A/S.
Citing diplomatic sources close to the talks, the Times said European governments were prepared to "concede a unilateral revocation of the withdrawal treaty by Stormont after a period of time".