Air France has confirmed it is to join forces with Dutch KLM and that Italy's flagship carrier Alitalia is also negotiating to enter the deal.
The creation of Air France-KLM will form an aviation
giant with annual revenue of about 19.2bn euros (£13.4bn; $22.4bn), overtaking British Airways and Germany's Lufthansa.
The deal will reshape the future of the aviation industry and create the world's third largest airline in terms of traffic after the two biggest US carriers.
But passengers are unlikely to notice much difference as KLM and Air France will continue as separate operating companies with their own brand identities.
Consolidation of the airline industry has been expected for some time as many of the world's largest carriers are struggling with heavy losses.
Air France chairman Jean-Cyril Spinetta said the industry had become too fragmented and not sufficiently profitable.
The airlines compared (2002)
Sales: 12.7bn euros
No of passengers: 43m
Profits: 111m euros
Sales: 6.5bn euros
No. of passengers: 16m
Loss: 133m euro
"The time has come to change," he told a news conference on Tuesday.
KLM chief Leo van Wijk said the partnership would secure a
sustainable future for the Dutch company, which has been in financial difficulty for some time.
It has already made several failed attempts to merge with British Airways, and walked away at the last minute from a deal with Alitalia in 2000, and has been negotiating with Air France for more than a year.
KLM and Air France will be placed under a new common holding company, after a share swap agreement that values the Dutch company at 784m euros and leaves Air France as the dominant partner.
KLM shares rose 19% following the announcement but Air France stock fell by 4.6%, as investors worried that the Dutch airline would hamper rather than help Air France.
KLM ran up losses of 271m euros last year, whereas Air France made an 111m euros profit.
Although the tie-up is effectively a takeover by Air France, the airlines will retain their separate identities because of bilateral aviation agreements between their governments and third countries which dictate where airlines can fly.
KLM's search for a partner
1991: Starts talks with BA
1992: Talks break down
Jan 1993: Starts talks with SwissAir/Austrian Airlines
Nov 1993: Talks break down
1997: Signs agreement with Alitalia
1999: Seeks partnership with Air France
April 2000: Breaks partnership with Alitalia
June 2000: Re-starts talks with BA
Sept 2000: BA talks break down
Oct 2001: Re-starts talks with BA
Jul 2002: Opens talks with Air France
Aug 2003: Breaks off talks with BA
Sept 2003: Seals deal with Air France
The European Commission has won a mandate to negotiate with the US to replace all these bilateral transatlantic agreements with a single pan-European deal, and analysts expect more mergers once these rules are modified.
Under the terms of the deal, the French Government's 54.4% stake in Air France will be diluted to 44% in the new company.
Alitalia, which is 62% controlled by the Italian state, is likely to be able to join Air France-KLM only after further privatisation, industry sources said.
Air France will offer 11 of its shares plus 10 Air France warrants for every 10 KLM shares.
Three warrants give the holder the right to buy two Air France shares at 20 euros apiece after 18 months.
The deal, effectively a takeover by Air France, values KLM at 784m euros - a 40% premium over KLM's stock market value at the close of trade on Monday.
Air France shareholders will own 81% of the combined company while KLM shareholders will have 19%.