The paper said the two firms have held "exploratory" talks over a possible deal which would create a �7.5bn ($11.7bn; 10.9bn euro) pan-European telecoms giant.

However, any possible deal between the two firms is still thought to be a long way off.

"This is a speculative report on which we don't comment," a spokesman for MMO2 said.

"Our strategic focus is organic growth," he added.

Good fit?

The Observer cited "informed sources" as saying that informal talks had taken place but that no discussions were currently taking place.

"Talks between management teams have taken place in the form of a 'get to know you' meeting," the source told the paper.

"But if anything does happen, it will still be a long way off."

Analysts have speculated for some time that the two firms may get together, as they are seen as being a good fit.

MMO2 is strong in the UK and Ireland while KPN has a major presence in the Netherlands and Belgium.

It is also argued that MMO2's German operation would help to bolster KPN's operation in the country.