"BAE Systems plc and EADS confirm that they are in discussions regarding a possible combination of their businesses," the companies said in a joint statement that confirmed feverish market speculation.
The talks envisaged BAE Systems owning 40 percent of the enlarged group, with Paris-listed EADS holding a majority 60-percent stake.
"The potential combination would create a world class international aerospace, defence and security group with substantial centres of manufacturing and technology excellence in France, Germany, Spain, the UK and the USA," it added.
The new group would manufacture products ranging from Airbus passenger jets and military transporters to Challenger tanks, Tornado jet fighters and aircraft carriers.
The merged company would have a unified board and management structure with identical boards and executive committees at each of BAE and EADS.
"This potential combination would be implemented through the creation of a dual listed company structure, under which both companies would operate as one group by means of equalisation and other agreements but would be separately listed on their existing exchanges," the statement added.
The two groups have a history of collaborating. They are already partners in joint ventures including the Eurofighter project and MBDA missile systems.
BAE is an expert in the field of defence, security and military, whereas most of EADS's work is in the commercial sector with its Airbus jet division.
A merger would help EADS make headway in the United States, which until now it has struggled to do, Guy Anderson, Senior Principal Analyst at IHS Jane's Defence Industry said.
"BAE systems now is far bigger in the US than it is in Europe" he pointed out.
In Washington, Boeing's chief Jim McNerney said Wednesday they saw no threat from the planned proposed merger.
"I have a pretty deep and abiding faith in our company's strength, okay, so I don't see this as something that is going to threaten us fundamentally," he said.
"I think this may be a matter of, from an EADS standpoint, maybe some increased US market access" because of BAE's presence in the United States.
Under the plan being discussed, the two groups would issue special golden shares in BAE Systems and EADS to each of the French, German and British governments.
This would replace Britain's stake in BAE Systems and the Franco-German stakeholder arrangement in EADS, the pair said.
EADS would pay £200 million to its shareholders prior to completion of a transaction.
Both groups said Wednesday that they have held talks with a "range" of governments across the world over the proposed deal.
"BAE Systems and EADS operate highly secure and sensitive defence businesses in the USA, the UK, France, Germany, Spain, Saudi Arabia and Australia, amongst other countries," they said.
"Discussions have therefore been initiated with a range of governments about the implications of the potential transaction."
In a separate development, Britain said any merger between the two groups would have to protect the public interest.
"The business benefits of any such arrangements are a matter for the companies involved," a British government spokesman said. "Given the nature of the companies' activities we would of course want to ensure that the UK's public interest was properly protected."
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France's government would give its view once it knew the details of the deal, French Finance Minister Pierre Moscovici said in a statement.
BAE and EADS added that they had agreed to ringfence certain defence activities, especially in the United States.
"Under the transaction structure being discussed... BAE Systems and EADS envisage that certain of their defence activities would be ringfenced with governance arrangements appropriate to their strategic and national security importance, particularly in the USA, given the importance of that market to the enlarged group," the statement added.
News of the proposed deal, which remains subject to shareholder approvals, sent BAE shares surging – but EADS stock dived.
BAE shares rocketed 7.39 percent to 353 pence on London's FTSE 100 index of leading companies, which finished 0.17 percent down at 5,782.08 points.
In Paris, EADS stock sank 5.63 percent to 28 euros on the CAC 40, which ended up 0.18 percent at 3,543.79 points.
In recent years, BAE Systems' performance has been hit as military budgets were cut in Britain and in the US and has axed 22,000 jobs over the past three years in response to reduced military spending around the world.