LONDON (Reuters) - German Chancellor Angela Merkel will try to narrow divisions that threaten to wreck a European Union budget deal and further isolate Britain from its biggest trading partner when she meets British Prime Minister David Cameron in London on Wednesday.
Cameron, under pressure after suffering a humiliating defeat in parliament at the hands of anti-European rebels in his Conservative Party, will have a working dinner with Merkel after threatening to veto the EU's seven-year 2014-20 spending plan.
There is growing anger among German officials over what they see as Britain's semi-detached stance towards the EU that could lead to London sliding out of a 27-nation union distrusted by public opinion and a sceptical media.
"This constant litany that we must do everything to keep Britain in the EU leads to a permanent state of blackmail by our British friends," former German EU ambassador Dietrich von Kyaw told a seminar of the Institute for European Politics in Berlin on Tuesday, venting a mood of exasperation among policymakers.
Cameron has called for a real-terms freeze in EU spending to reflect national austerity policies and has threatened to block a deal otherwise, potentially holding up an increase in funding for the poorest new east European member states.
He has also ruffled feathers in Europe by talking of using closer euro zone integration as an opportunity to repatriate some powers from Brussels.
In a veiled reprimand last week, Merkel said veto threats would not help the EU's tense budget negotiations. Germany is the biggest net contributor to the budget while Britain, which receives an annual rebate on its payments to Brussels, is the four largest net payer after France and Italy.
The British parliament put Cameron under the gun last week by passing a non-binding motion calling for a real-terms cut in European spending, and hardline rebels threaten to vote down any other negotiating outcome.
The prime minister isolated Britain a year ago by vetoing an EU treaty change to enforce stricter fiscal rules in the euro zone. All other member states except the Czech Republic signed a separate treaty instead to circumvent the British obstacle.
France and Denmark have also threatened to block a budget deal to press their interests, highlighting the obstacle course facing EU leaders at a November 22-23 meeting in Brussels.
The talks between Merkel and Cameron must come up with "something extraordinary" if the 27-member bloc is to reach a deal, one euro zone government source said.
"I am very pessimistic that it will come to a solution in November unless Merkel and Cameron show the way on Wednesday," he said. "The basic problem for me is how we can get to a solution after Britain said 'no'."
The budget accounts for just over 1 percent of EU gross domestic product, compared to between 40 and 56 percent spent on national budgets.
Most EU money is spent on agriculture (around 40 percent) and regional development in poorer parts of the bloc (about 35 percent), with the balance going on research, overseas development aid and 6 percent on administration.
Britain's anti-European UK Independence Party seized on an official auditors' report on Tuesday which found substantial errors in EU spending last year, saying it demonstrated that Europe mismanages its finances.
The European Court of Auditors, which checks EU institutions' finances, said it found irregularities affecting 4 percent of total 2011 spending, equivalent to 5.2 billion euros.
"If this report...doesn't set alarm bells ringing in Downing Street then nothing will," said Marta Andreasen, a UKIP member of the European Parliament.
Euro zone officials said British and German sherpas -- the leaders' personal negotiators -- have been meeting regularly in recent weeks to narrow their differences on the EU budget in preparation for Wednesday's meeting.
They said London and Berlin were not very far apart in their positions, with Cameron and Merkel agreeing at a meeting before the last EU summit in October that a "realistic budget" needed to be agreed and that the European Commission's proposal for a 6 percent increase was unacceptable.
One key to negotiations with Britain would appear to be the base year used to measure a "real-terms" freeze. Cameron has set 2011 as the starting point, but there may be some flexibility on that baseline, allowing room for a compromise.
Cyprus, the rotating president of the EU responsible for preparing the budget talks, opened with a proposal for a 50 billion euro cut on the European Commission's 1,033 billion euro draft seven-year spending plan.
But at a meeting among EU ambassadors last week, the office of Herman Van Rompuy, the president of the European Council who chairs EU summits and will now take over negotiations, proposed a deeper, 75 billion euro reduction.
Officials familiar with Britain's position said 75 billion euro was still insufficient, but would not be drawn on how much more needed to be cut.
Depending on what figures are used - the EU budget is based two calculations, one on money that is committed and the other on what is actually paid out - most officials believe Britain wants to see a reduction of around 120-150 billion euro, although that will depend on the base that is finally agreed.
"There's still some time before November 22," said one EU official dealing with the talks, saying there would be a lot of number-crunching and accounting gymnastics in the next two weeks to try to bridge the gap between Britain and other EU members.
(Additional reporting by Matt Falloon in LONDON, Luke Baker and Charlie Dunmore in BRUSSELS and Stephen Brown in BERLIN; Editing by Paul Taylor)
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