It will pay £851m in cash and assume £1.05bn in debt for the deal.

East Midlands, which supplies electricity to over two million homes and businesses, was bought by its current owner, the American power company Dominion Resources, in 1996 for £1.3bn.

With headquarters in Nottingham, it employs 4,500 people.

Some generating capacity may have to go

PowerGen, which is Britain's third largest generator, operates 11 power stations in England and Wales, supplying just under 20% of electricity capacity.

The move creates an integrated energy supply and distribution company which will be able to take advantage of the deregulation of the domestic electricity market in the autumn.

Powergen Chairman Ed Wallis on merger with E. Midlands Electricity

Ed Wallis, Chairman of PowerGen, said the deal would be good for shareholders, customers and employees of the two companies. "This transaction represents a significant step forward, structurally, the move creates a strong growth platform in the converging electricity and gas markets."

Regulatory approval needed

The deal will need the approval of regulators, but PowerGen says it believes competition issues can be resolved by the company selling some of its generating capacity.

It is believed that the company plans to sell at least one of its coal-fired power stations, possibly at Ferrybridge, Yorkshire. It has already said it will dispose of its oil and gas assets, which could raise around £400m.

It says it will be making submissions to the Office of Fair Trading and the industry regulator, Offer.

The deal comes at a sensitive time, as the government is trying to encourage the generators to sell capacity as part of its energy review.

PowerGen and its slightly larger rival National Power hold 40% of the generating market between them. The industry regulator Stephen Littlechild has said that at least one-fifth of that generating capacity should go in order to encourage more competition. National Power has been resisting calls to sell any of its plants.

PowerGen tried to buy Midlands Electricity, a neighbour of East Midlands, two years ago but the deal was blocked by the previous Conservative government. It is rumoured to be in talks with Midlands' American owners, Houston Industries, for a full-scale merger.