By Elizabeth Howcroft

LONDON, Oct 1 (Reuters)Sterling fell against the dollar and the euro on Thursday after a report that Britain and the EU were still far apart on the key issue of state aid in Brexit trade talks, with the launch of an EU legal case against the UK dealing another blow.

British and EU trade negotiators have failed to close the gap on state aid rules, an issue which is preventing them from reaching an agreement on post-Brexit trading rules, officials and diplomatic sources said.

Britain said there are still differences between the two sides in negotiations, but that London will work hard to try to secure a deal before its transition period after leaving the bloc ends on Dec. 31.

The pound, which had started the day slightly up against a weaker dollar, fell on the news that the EU and UK were still far apart.

At 1014 GMT, sterling was down 0.6% versus the dollar at $1.2843 GBP=D3. It was also down around 0.6% versus the euro at 91.4 pence per euro EURGBP=D3.

A gauge of sterling overnight volatility rose to its highest since March GBPONO=FN.

“It’s challenged the prevailing market consensus that had been built up over the last couple of weeks, rightly or wrongly, that they were getting closer to a deal,” said Timothy Graf, head of macro strategy for EMEA at State Street Global Markets.

Graf said the chance of a deal not being reached is around 50%, and that this risk is not fully priced into the pound.

Speculators do not have a net short position on the pound, weekly futures data for the week to Sept. 22 shows 1096742NNET.

The EU on Thursday launched a legal case against Britain over its new Internal Market Bill that undercuts earlier legal commitments made by London in its Brexit divorce treaty.

“The Internal Market Bill legal action was expected and not news to the market, but sterling is very sensitive to Brexit headlines as the deadline approaches,” said Ian Tew, a sterling trader at Barclays.

“Today’s news once again made the market nervous that a deal or the tunnel is not imminent, taking away from any recent positive sentiment and therefore GBP unwinding gains.”

The “tunnel” is a stage of intensified negotiations, where small teams work to reach a compromise.

Banks have raised their forecasts for the likelihood of a no-deal Brexit.

Britain’s lower house of parliament approved the Internal Market Bill on Tuesday and it is now with the upper house.

This week’s round of Brexit talks is the last currently scheduled and EU leaders will assess progress on Oct. 15-16.

Sterling most volatile G10 currency

(Reporting by Elizabeth Howcroft; Editing by Catherine Evans)

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