* EU leaders divided on crisis response
* Italy, Spain hold up growth package to demand urgent support
* Focus on using EU rescue funds to buy Spain, Italy bonds-sources
* Merkel says budget control must come before debt sharing
By Luke Baker and Catherine Bremer
BRUSSELS, June 28 Italy and Spain, battling searing market pressure in the euro zone's widening debt crisis, blocked agreement on measures to promote growth at a European Union summit on Thursday to demand urgent action to bring down their borrowing costs.
Italian Prime Minister Mario Monti and his Spanish counterpart, Mariano Rajoy, refused to sign off on a 120 billion euro ($149 billion) growth package until EU paymaster Germany approved short-term measures to ease their cost of credit.
The clash highlighted tensions between northern creditor countries and heavily indebted southern states over the future shape of the troubled 17-nation currency bloc, now in the third year of a sovereign debt crisis.
Hours later than planned, European Council President Herman Van Rompuy came out to announce a deal in principle on measures to stimulate infrastructure investment and give more capital to the EU's soft-lending arm, the European Investment Bank.
"There's no blockage, we keep on working and we move on," he told a belated news conference, playing down the row.
However, French President Francois Hollande confirmed that Italy and Spain had withheld approval of the growth pact until euro zone leaders agree short-term measures to stabilise markets, but said he expected a deal on Friday.
"Everyone must make an effort so that markets are convinced that the measures are effective, and they must be," Hollande told a news conference. "We all need Italy and Spain to have lower interest rates today and for Spain's banks to be recapitalised because that will bring relief for the euro zone."
Senior finance officials, meeting during the summit, proposed setting up a single supervisory authority for euro zone banks involving the European Central Bank, and letting the bloc's rescue fund recapitalise banks directly, subject to conditions, a document obtained by Reuters said.
The document, to be put to leaders, said the temporary EFSF rescue fund and its permanent successor the ESM would be used "in a flexible and efficient manner" to stabilise markets.
Rome and Madrid want to see steps to allow the rescue funds to buy their government bonds and lend money directly to recapitalise Spanish banks without adding to the public deficit.
"There's an epic battle going on between those who seek immediate and unconditional solidarity and those who seek to fundamentally change the way European economies are run and put Europe on a course of stability, discipline and growth," one EU official said after nearly eight hours of debate.
Merkel cancelled a news briefing as the argument dragged on through the evening. The summit agenda was upended to enable euro zone leaders to hold a post-midnight discussion on the future of their troubled 17-member currency union.
It was the 20th EU summit since the sovereign debt crisis began in early 2010 after Greece disclosed its public deficit was far higher than previously reported.
Policymakers played down any prospect of a definitive solution to the turmoil that has forced Greece, Ireland, Portugal and now Spain and Cyprus to seek international bailouts.
As the leaders argued, Italy beat Germany 2-1 in the Euro 2012 soccer semi-final, the underdog knocking the favourite out of the contest.
In draft summit conclusions, subject to amendment on Friday, the leaders were set to ask the EU's top four officials to produce a detailed, time-bound roadmap in December leading to a genuine economic and monetary union.
But markets may not wait that long.
Italy's benchmark borrowing costs hit six-month highs at auction on Thursday, piling pressure on Monti to ease squeeze concessions out of Germany.
Rome and Madrid have been pleading for help but received a cool response from Berlin and other capitals so far.
The rescue funds will have a maximum firepower of 500 billion euros ($625 billion) once the ESM is fully stocked in 2013, minus 100 billion euros already earmarked to aid Spanish banks.
The sources said the preferred creditor status of ESM loans to Spain, which has spooked investors who fear they would be last to be paid back in the event of a default, was likely to be removed if Madrid issues covered bonds backed by state assets or tax revenues.
Italy and Spain would still have to request assistance, which they have been loath to do, and would be subject to fiscal policy conditions and international monitoring. But they might not be required to do more in austerity and structural reforms than they have already undertaken, the sources said.
"NEIN! NO! NON!"
Merkel was being urged at home to reject all efforts to make Germany underwrite European borrowing or banks, which some of her partners say may be the only way to save the single currency.
"Nein! No! Non!" shouted a headline splashed across the front page of the normally sober German business daily Handelsblatt.
Monti was also under mounting domestic pressure to achieve results in reducing Rome's borrowing costs or risk seeing his technocratic government fall within months as the parties that support him jockey for position before an election due in 2013.
Van Rompuy and European Commission President Jose Manuel Barroso have set long-term goals of creating a euro zone treasury to issue joint bonds in the medium-term, and establishing a banking union with central supervision, a joint deposit guarantee and a resolution fund.
Merkel insists that fundamental reforms to give European Union authorities power to override national budget and economic policies must come before any further shared liability.
The euro hit a three-week low and world stocks fell as investors bet that this latest summit would fail to produce concrete measures to tackle the crisis, sending 10-year Spanish government bond yields above the danger level of 7 percent.
France's Hollande advocates joint "eurobonds", which would bring down borrowing costs for the weak because the pool of guarantors would include the strongest - principally Germany.
Germany does not want to use its top credit rating to support others unless they share control of tax and spending powers first. Dutch premier Mark Rutte sided with Merkel in arguing against any early move to share liability.
"It's crucial for us to avoid taking measures that would ease pressure on southern Europe to reform," he said.
Finnish Europe Minister Alex Stubb told Reuters that Europe should prepared to live in a state of crisis for the rest of the decade. But he said a stronger and more resilient continent would eventually emerge.
"It is an existential crisis, but it's probably the best crisis we've had. It's forcing European leaders to take very difficult decisions and as we all know very few difficult decisions have been taken in a relaxed atmosphere," he said.