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"He has bowed to Mr Sarkozy's demand that the goal of 'undistorted competition' should be removed from the introduction to the treaty. Mr Sarkozy wanted this because he says that, philosophically, the French don't regard competition per se as a good thing, merely as a means to an end.

"It is an important concession, because it will help Mr Sarkozy to present the deal to his own voters, and to fend off questions of a referendum. It helps Mr Sarkozy to explain that he has fulfilled his election promises."

It was French as well as Dutch voters who voted down the proposed European constitution in a referendum in 2005, throwing EU reform into chaos.

Mr Blair’s spokesman said the UK delegation now had a "better understanding" of the French position. After taking legal advice, Britain was confident that the change would not water down European competition law.

"For us, what matters is, is it elsewhere in the treaty?" said the spokesman.

"It is - 13 times. Therefore I think as a result of this morning’s meeting, clarification is emerging on this issue. It crosses French sensitivities and we have to be aware of French sensitivities."

But John Cridland, Deputy Director-General of the CBI, deplored the concession. He said: "This is a regrettable and frustrating last-minute development. It is not just a cosmetic change - it represents a long-term threat to free competition and will strengthen the hand of protectionists within the EU in the years ahead.

"There must be no more concessions. The UK Government should not accept the EU charter of fundamental rights within the legal framework of the treaty, as it would pose an unacceptable risk to the UK's flexible labour market."

William Hague, Shadow Foreign Secretary, said: “It looks as if our Government has just agreed to rip out the jewel in the EU’s crown. Ensuring free and open competition in the EU is what the EU does best. It has made our economies more competitive and brought down prices across the board.

“This is an astonishing climbdown and EU officials and legal experts are rightly alarmed."

Early in the afternoon the leaders managed to reach broad agreement on another stumbling block - the job title, role and powers of the EU’s future foreign policy representative.

Under the deal, the foreign policy chief would be called High Representative of the European Union, and serve also as vice-president of the executive European Commission, but would not get the title of "foreign minister" as in the constitution - a name that raised British hackles.

They would however chair meetings of EU foreign ministers, and also head a combined external action service drawing on both national and EU diplomats, after Britain dropped its reservations on those points, the diplomats said.

The run-up to the summit has already seen some of the toughest European negotiations for years.

Britain is seen as one of the main obstacles to Ms Merkel’s aim of agreeing a mandate, which could then be put to an inter-governmental conference later in the year to thrash out the final text of a treaty to reform EU structures.

Mr Blair’s spokesman this morning said that there was now "greater realism" among other EU states about the fact Britain was prepared to block a deal rather than back down on its four "red lines".

"It is a simple fact of life that from our perspective there will not be a deal unless the four red lines are met," said the spokesman.

"That’s a simple fact of life and therefore, for the other countries, that’s a reality that they will have to deal with."

The red lines state that nothing in the treaty should impinge on Britain’s ability to determine its own labour laws, foreign policy, domestic law on issues such as tax and benefits, and its criminal and jurisprudence legislation.

Britain is not the only country raising concerns about the draft treaty. Poland, in particular, wants changes to the proposed voting system for the European Council, which is weighted according to each country’s population.

Angela Merkel, the German Chancellor who is chairing the summit, has met Lech Kaczynski, the Polish President, three times in 12 hours to try to ease Poland’s resistance to planned changes to the voting system which Warsaw says would favour member states with larger populations.

“We’re working hard. The problems are not yet solved but everyone is trying,” said Ms Merkel.

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