BAE Systems has been left off the final shortlist for an �860m UK defence contract.

The Ministry of Defence said it had selected America's Northrop Grumman and France's Thales to bid for a 10-year contract to supply unmanned Watchkeeper spy aircraft.

The two companies had tendered for the contract along with BAE Systems and Lockheed Martin.

BAE have said say they will be joining the Northrup Grunman team and an announcement will follow later on Friday.

Rift speculation

But the MoD's decision is likely to fuel speculation of a rift with BAE, following cost over-runs on two earlier projects.

Last month, the government split a �3bn contract to build two aircraft carriers between BAE and French contractor Thales.

BAE was given the lead role, but the government gave Thales of France a one-third share of the work.

Suggestions in the Financial Times that BAE was being excluded from Watchkeeper as a quid pro quo for the carrier deal were denied earlier this week by MoD officials.

Announcing the Watchkeeper deal, Defence Secretary Geoff Hoon said: "We have today (Friday) selected Northrop Grumman ISS International and Thales UK to take forward the remainder of the assessment phase."

Budget over-runs

He said both bidders have said they would do the bulk of the work in Britain.

"The remainder of the assessment phase...will culminate by mid-2004 in the selection of a single successful contractor for the demonstration and manufacture phase," he added.

The government plans to appoint a preferred bidder next year.

The project is for an unpiloted aerial surveillance vehicle which will provide commanders with imagery from the battle field.

Relations between BAE and the government have been under pressure after cost over-runs estimated at up to �1bn in two earlier defence projects.

The defence giant went over budget in building the Astute submarine and upgrading the Nimrod sea patrol aircraft.