The two companies will issue a Stock Exchange announcement tomorrow confirming their plans, and expect to unveil the full terms of the deal in a fortnight.
The combined business will have sales of pounds 5bn a year, 115,000 employees and 7,200 outlets ranging from Firkin and Hogshead real ale pubs to Big Steak and Beefeater restaurants and Cafe Rouge and Dome bars.
To overcome competition rules limiting the number of tied pubs that a brewer is allowed to own, Whitbread will dispose of its beer division, which brews Boddington's, Stella Artois and Heineken, in a trade sale or flotation which could raise around pounds 750m.
The deal will leave Allied with just its drinks and spirits division, featuring brands such as Beefeater Gin and Ballentine's whisky and its two franchised chains, Dunkin' Donuts and Baskin Robbins ice-cream.
It is likely to take some of the pressure off Allied's embattled chief executive, Tony Hales, by allowing him to return cash to shareholders or re-inforce the portfolio of brands.
Alternately, Allied's drinks business could finally be swallowed by Seagram of Canada, with which Allied has held on-off merger discussions since the formation of Diageo through the merger of Guinness and Grand Metropolitan.
Sources close to the two companies insisted the deal should not encounter any other competition problems since the enlarged Whitbread business would still have only 15-16 per cent of the UK pubs and restaurants market.
There might be a number of regional concentrations, but even here the overlap is limited since Allied is strongest in the Midlands - an area where Whitbread is weakest.
In terms of restaurants, Whitbread will leapfrog the number one chain, McDonalds, while in pubs Bass and Scottish and Newcastle will become a distant second and third.
There had been speculation Whitbread was about to make a pounds 1.4bn strike for the Greenall's pub and restaurant chain but it is now clear this was a smokescreen to hide the Allied talks.
Whitbread will acquire Allied's 2,000-strong estate of managed pubs and its 1,575 chain of tenanted pubs, known as Vanguard. The managed pubs include 360 Big Steak restaurants, 185 Firkin real ale pubs and Scruffy Murphy's Irish pubs.
Together with Whitbread's Pub Partnerships' chain of tenanted pubs, the deal will create one of the biggest tenanted estates in the UK with 3,275 pubs.
Under the beer orders, which came into force in the early 1990s, Whitbread is not allowed to have more than 4,300 pubs. Selling off the brewing arm will enable it to get around this limit. Whitbread will have six months to complete the brewing sale.
Last year the brewing business made operating profits of pounds 44.6m on sales of pounds 996m. Estimates of valuation are complicated by the fact that it brews Stella and Heineken under licence.
The deal will not affect the long-term supply agreement Allied already has with Carlsberg Tetley to supply the Allied pub estate. This arrangement was put in place after the sale of Carslberg Tetley to Bass was blocked and Allied sold its share of the venture to Carlsberg.
The dramatic expansion of Whitbread's pubs and restaurants division will also enable it to roll out more of its Travel Inn budget hotels. It has 200 Travel Inns built alongside Brewer's Fare and Beefeater restaurants and wants to double the size of the chain. The acquisition of Allied's Big Steak restaurants will provide the opportunity for this.