By Gabriela Baczynska and John Chalmers

BRUSSELS, Oct 1 (Reuters)British and EU trade negotiators have failed to close the gap on state aid, a key element barring their new agreement on post-Brexit trade ties, officials and diplomatic sources with the bloc said as 27 national leaders gather in Brussels on Thursday.

The two-day summit in Brussels is due to deal with foreign policy but chairman Charles Michel and the bloc’s executive will also on Friday give their latest assessment on Brexit.

Disagreements over corporate subsidies, fisheries and ways to solve disputes have overshadowed trade talks, while a proposed UK law that would undermine its earlier divorce deal with the bloc triggered a new crisis last month.

Britain’s lower house of parliament approved the Internal Market Bill on Tuesday and it is now with the House of Lords. Britain say ensuring that its nations can trade freely with each other after Brexit would require breaking the divorce deal provisions on the sensitive Irish border.

The executive European Commission, which negotiates with Britain on behalf of all the bloc’s members, wants London to agree to broad state aid rules that would be compatible with those the EU has.

The bloc wants an independent British regulator to decide on state aid there, as well as seeks a new EU-UK dispute settling mechanism that would create a new Joint Committee and an Arbitration Panel to adjudicate.

Should one side fail to honour decisions made through that process, the Arbitration Panel could impose fines and the other side could retaliate by hitting bilateral trade elsewhere.

“The problem is that the UK doesn’t want to follow that path,” an EU diplomat following Brexit told Reuters.

An EU official, who is involved in the talks, echoed that: “It remains to be seen if the