SRM Global, Northern Rock's biggest shareholder, has raised the stakes in the battle over the beleaguered mortgage bank by writing to the Chancellor telling him it will sue the Government if the bank is nationalised.
In a personal letter to Alistair Darling, Jon Wood, the head of SRM, has attacked the handling of the Northern Rock crisis.
He specifically rejects the Government's acceptance that its support of Northern Rock is classed as state aid under European regulations. Both SRM and RAB Capital, the second-largest shareholder, have already made clear that they will not accept a private-sector solution to the bank's problems being proposed by Sir Richard Branson's Virgin.
The two hedge funds hold 19.68 per cent of Northern Rock between them, nearly enough to block the bid from Virgin, which needs the backing of 75 per cent of the bank's investors to go through. But the offer from Sir Richard Branson's group has been resisted by investors who would see their existing shareholdings in the bank heavily diluted.
SRM is arguing that the Government made a mistake in agreeing that European state aid rules apply to its support for Northern Rock, saying the Bank of England's moves just mirrored similar liquidity support provided to other banks by the European Central Bank.
The hedge fund also believes that the Government would have to pay out £4 a share to investors, the bank's book value, if it nationalises Northern Rock.
The Treasury is said to be confident that its support for Northern Rock comes under the European Commission's state aid rules after discussions with Brussels. It is in talks with Virgin, its preferred bidder, as well as Northern Rock's management team, which wants to run the bank as a going concern.
Northern Rock said last night that it had improved its in-house proposal by increasing the amount of new equity it would inject through a rights issue to at least £700m.
It also said it had offered improved terms to the Government but gave no details.
Sir Richard Branson's Virgin will submit a new proposal today that will seek to meet the Government's demands.
The Treasury wants Virgin to pay up to £200m for the Government to guarantee a bond issue by Northern Rock.
It also wants better terms on the warrants that Virgin would give the Government so that taxpayers can share in a recovery at Northern Rock.
The Treasury is demanding a lower hurdle for the warrants to pay out and a four- or five-year duration so that they last for longer than the three-year term of the Government's guarantee.
The Treasury is said to be ready to make a decision this evening so that the Government can make its own decision over the weekend.
An announcement could come as early as Monday, when Parliament returns, but it could slip to Tuesday or later. However, the European Commission has to agree that any deal does not breach state aid rules. A decision from Brussels may not come before this summer.
Northern Rock has been in crisis since September last year, when soaring borrowing costs forced it to seek emergency funding from the Bank of England.
The revelation put the lender at the centre of the UK's first bank run for more than 140 years.