* Dispute is latest setback for Brussels' regulation drive
* Row over giving foreign funds licence to operate in EU
* Stand-off comes as European leaders prepare for G20 talks
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By John O'Donnell
BRUSSELS, June 23 (Reuters) - Controversial EU rules for hedge funds hung in the balance on Wednesday with European lawmakers and diplomats in a stand-off that some warned could spoil Brussels' attempts to overhaul the regulation of finance.
It is the latest in a series of rows between the bloc's 27 countries and the European Parliament, which have an equal say in writing European law. Talks to set up watchdogs for policing banks, insurers and markets are also deadlocked. [ID:nLDE65L1JB]
The stand-off is taking place shortly before EU leaders including German Chancellor Angela Merkel and French President Nicolas Sarkozy travel to Toronto for a meeting of the Group of 20 major economies.
They want to champion Europe as a model for ambitious regulation but an impasse over hedge funds and watchdogs means the EU is struggling to write laws while U.S. President Barack Obama is to sign off on rules within weeks to control finance.
"We need statesmanship, not brinkmanship," said one European Union diplomat. "The stakes are too high. By parliament reaching for the impossible, we could all end up with nothing."
At the heart of the row is a passport scheme or licence to do business throughout Europe for foreign hedge funds. Lawmakers want to block the entry of foreign funds that fail to qualify for a licence because they do not meet EU standards.
But countries such as Britain, home to nearly all European hedge funds, want to give funds that fail the EU passport test a second chance by letting them apply for a licence to operate in individual countries.
Parliament, which is keen to flex its muscles having last year won extra powers to change or veto almost all European laws from banking regulation to agriculture and immigration, is reluctant to give ground.
"The parliament is not budging," a source at the assembly said. "It is passport or nothing. If you don't meet the criteria that are laid out you won't be able to market in the EU."
Michel Barnier, the European commissioner in charge of an overhaul of banking regulation, and his officials have been shuttling between meetings, attempting to defuse the row.
The former French foreign minister fears that should diplomats and lawmakers not agree next week, they could miss an early summer deadline to finalise the laws.
Such a delay would put a question mark over Europe's efforts to control the financial sector.
Diplomats and lawmakers would return to the negotiating table as late as September after the parliament and the executive European Commission return from their summer holidays.
"If you look at the EU legislative response to the crisis, it has produced surprisingly little," said Nicolas Veron, a financial policy expert with think tank Bruegel.
"On many points, it has not even got started while America is preparing to sign in its financial bill. Disputes like this highlight the shortcomings in EU policy elaboration."
For a factbox on how European rules would curb hedge funds, double click on [ID:nLDE65M0YF] (Additional reporting by Julien Toyer and Ilona Wissenbach, editing by Dale Hudson)