* Peugeot board agrees outlines for Dongfeng deal - sources
* Two-stage share issue would raise 3 bln euros - Peugeot says
* Negotiations now to focus on price gap - source (Updates paragraph 4 with confirmation from France)
By Laurence Frost and Sophie Sassard
PARIS/LONDON, Jan 20 (Reuters) - French carmaker PSA Peugeot Citroen has taken a decisive step towards a tie-up with China's Dongfeng Motor Co. as the board approved the outlines of a contentious survival plan that divided the founding Peugeot family.
In a blow to Chairman Thierry Peugeot, who had championed an alternative plan, the board agreed in principle to a capital increase that would see the Chinese state-owned carmaker and French government acquire minority stakes and the family cede control, sources familiar with the matter said on Monday.
Peugeot confirmed in a statement that it was looking to raise 3 billion euros ($4.1 billion) in a deal with Dongfeng, after unveiling a further 4.9 percent decline in global vehicle deliveries for 2013 earlier on Monday.
The French government would subscribe to the share issue "on the same terms and conditions as Dongfeng", Peugeot said, an assertation later confirmed in a joint statement from French Finance Minister Pierre Moscovici and Industry Minister Arnaud Montebourg.
The company's shares fell 11 percent on news of the board decision to press ahead with the planned deal, which would dilute existing shareholders.
"We're sceptical about this kind of plan - a very dilutive capital increase for a weak industrial project," said Florent Couvreur, a Paris-based analyst with CM-CIC Securities.
The operation would leave "three main shareholders with conflicting objectives", Couvreur added in a note to investors. "This is a rejection for Chairman Thierry Peugeot."
Peugeot has said it will need fresh funding to stay competitive and is pursuing talks on a deeper relationship with Dongfeng, its existing partner in a Chinese joint venture.
The two carmakers have been in discussions for months to extend cooperation to other Asian countries, backed by a multi-billion-euro share issue in which Dongfeng and the French government would acquire significant stakes.
Peugeot, one of the worst casualties of a six-year European market slump to a two-decade low, is expected to confirm next month that it burned through about 1.5 billion euros in cash last year in addition to restructuring costs.
Peugeot said its plan would raise capital in two stages, starting with a reserved capital increase in which Dongfeng and the French government would acquire matching stakes.
Both would then acquire more shares in a broader issue to the market.
With market conditions showing signs of improvement, Thierry Peugeot had pushed an alternative deal replacing the French government's role with a bigger market issue, potentially allowing the family to remain the biggest shareholder, a source with knowledge of the matter said.
The Peugeot clan currently controls the carmaker through a 25 percent stake commanding 38 percent of voting rights.
But French ministers rejected that initiative, and the board gave its agreement in principle late on Sunday to a deal in which the family, French government and Dongfeng would end up with equal holdings, the person said.
The government "will do everything and use its influence to ensure PSA remains a major French carmaker," Finance Minister Pierre Moscovici said before the meeting.
The chairman's push for an alternative had also divided the family and management, two sources said, because it departed from the framework backed by cousin Robert Peugeot, who heads the FFP family holding, and outgoing CEO Philippe Varin.
Thierry Peugeot's eventual replacement by a new independent chairman is now a given, according to one, with the French state favouring Louis Gallois, a senior civil servant and industrialist who already sits on the Peugeot board.
The green light clears the way for negotiations in earnest on the deal price, with Dongfeng so far willing to offer about 7 euros and Peugeot holding out for 8 euros per share, one of the people said.
The size of the matching stakes - likely between 10 percent and 15 percent - will depend on the deal pricing and market conditions, which may also affect the relative size of the reserved share sale and market offering, the sources added.
Dongfeng and the French state would each contribute between 500 million and 800 million euros, according to one, with the Peugeot family also paying 100 million euros for new shares.
Peugeot said it hoped to announce a deal along with the publication of full-year results on Feb. 19, adding that it was also studying "alternative capital increase scenarios".
"The company cannot give any assurance regarding the outcome of the project," Peugeot added.
The carmaker said its 2013 vehicle sales were weighed down by a 7.3 percent decline in Europe, where the Paris-based company does more than half of its business by volume.
The overall decline overcame gains in Latin America and China, where sales rose 26 percent to 557,000 vehicles.
Sales also tumbled 22 percent in Russia, and the company lost a further 144,000 deliveries of semi-assembled vehicles as a result of U.S.-led sanctions that have crippled Iranian production by Western automakers.
Varin will be replaced later this year by former Renault second-in-command Carlos Tavares, who joined Peugeot as CEO-in-waiting on Jan. 1. ($1 = 0.7373 euros) (Additional reporting by Gilles Guillaume; Editing by Mark John, Mark Potter and David Evans)