The European Commission has proposed forcing carmakers to increase the fuel efficiency of new cars by 20%, by 2012.
Transport produced 28% of the EU's CO2 emissions in 2004
It says it is planning legislation to ensure the average car emits no more than 130g of CO2 per kilometre, compared with 162g/km in 2005.
The car industry described the EU target as "arbitrary" and said it would lead to a loss of jobs and relocation of production overseas.
But environmentalists said the proposal did not go far enough.
Industry Commissioner Guenter Verheugen urged the industry to see the commission's proposal as a spur to innovation.
"The motor industry faces a major challenge... I would urge them to face up to it and not consider it a burden but consider it a positive challenge," he said.
He added: "We will shortly be in a position to provide not only the safest and best cars, but also the cleanest cars - that is the future of the European automobile industry."
Environment Commissioner Stavros Dimas said that without the action the commission was proposing, the European Union would not meet its greenhouse gas emission targets under the Kyoto treaty, or any post-Kyoto commitments.
The commissioners assured carmakers that the 130g/km average would not apply to each individual manufacturer, but to the industry as a whole.
They said the precise definition of the regulatory approach would be decided later.
But the European Association of Automobile Manufacturers (ACEA) said the commission's proposals focused too much on vehicle technology and not enough on other mechanisms to bring down emissions, such as taxes and better fuels.
"If left unchanged, the commission proposal would erode the economic strength of Europe," said ACEA president Sergio Marchionne.
The commission proposed measures last week to increase the use of biofuels. It also wants member states to impose higher taxes on high-emitting cars, but some governments routinely veto tax harmonisation.
Mr Dimas had wanted an upper limit of 120g/km but was forced to compromise, after strong opposition from the German car industry and from Mr Verheugen.
The commissioners said their proposal envisaged the target of 130g/km being reached thanks to new car technology, but further measures, including increased use of biofuel, would mean that cars overall emitted no more than 120g of CO2 per kilometre by 2012.
Jos Dings of the environmental pressure group Transport and Environment (T&E) said the 130g/km limit was a "disappointing response" to the calls last week by a UN panel of experts for serious action on climate change.
He said the retreat from Mr Dimas' preferred 120g/km fuel-efficiency target, was a "reward" to the car industry for making insufficient progress towards its voluntary target of 140g/km by 2008.
He called for the EU to fix an 80g/km limit for 2020.
Transport is the only sector in Europe that has shown dramatic increases in CO2 emissions over the last 15 years.
AVERAGE CAR C02 EMISSIONS
2008: 140g/km (voluntary industry target)
2012: 130g/km (European Commission proposal)
2020: 80g/km (target proposed by T&E)
The car industry has made huge improvements in engine efficiency, but the power, size and weight of cars have also increased rapidly.
As a result, CO2 emissions have only fallen by 23g/km from the 1995 level of 185g/km.
Mr Verheugen said discussions would continue with scientists, research institutes, manufacturers and other interested parties, as a detailed impact assessment was carried out.
Legislation is likely to be drafted later this year, or early in 2008. It will then need to be approved by member states and the European Parliament.