The Justice Department on Wednesday sued to block AT&T Inc.'s T 0.74% proposed $39 billion takeover of T-Mobile USA, a surprisingly swift move that dealt a blow to AT&T's ambition to build the largest U.S. cellphone carrier.

The government said the combination of the second- and fourth-largest cellphone companies in the U.S. would harm competition and likely raise prices for consumers.

The department of justice is seeking to block AT&T's takeover of T-Mobile. Deal Journal's Shira Ovide joins Markets Hub with details on how the suit could impact the telecommunications sector. (Photo: AP Photo.)

The antitrust challenge came just five months after the deal was announced, catching AT&T off guard. The Dallas-based communications giant vowed to fight to preserve its prize deal, setting up one of the most significant antitrust court battles in recent years.

The lawsuit is the Obama administration's boldest antitrust challenge to date and the latest evidence of its intention to reinvigorate enforcement after what it says was a lull during the previous administration.

In May, the Justice Department threatened to file a suit blocking Nasdaq OMX Group's NDAQ 1.10% proposed $11.3 billion bid for NYSE Euronext, which would have joined the two biggest stock exchanges in the U.S. Nasdaq subsequently dropped its bid.

The T-Mobile acquisition "would result in tens of millions of consumers all across the United States facing higher prices, fewer choices and lower quality products for mobile wireless services," said James Cole, deputy attorney general.

AT&T said it was "surprised and disappointed" by the suit. As recently as the past week, AT&T got the impression from a meeting with Justice Department officials that discussions had already moved beyond the deal itself to possible remedies that would satisfy the government's concerns, said one person familiar with the matter.

AT&T had argued it would be able to use T-Mobile's towers and airwaves to more quickly improve wireless service quality and expand high-speed wireless Internet service across most of the U.S. AT&T also argued that the deal would create jobs by expanding broadband access.

T-Mobile USA chief Philipp Humm, center, prepared to speak at a Senate Judiciary Committee hearing in May on the proposed deal with AT&T. Bloomberg News

The share prices of AT&T and T-Mobile parent Deutsche Telekom AG DTEGY 0.37% fell sharply, while shares of No. 3 cellphone company Sprint Nextel Corp. , seen as the biggest loser if the proposed merger goes through, were up nearly 6%.

Deutsche Telekom was also surprised by the Justice Department's move, according to people familiar with the company, but it feels it is well-protected if the deal collapses. That's because AT&T has agreed to pay $6 billion in cash and other considerations if the deal fails to clear regulatory review.

The breakup fee includes extra U.S. radio spectrum for T-Mobile, which it could use for high-speed data networks if it must remain independent. Deutsche Telekom, unwilling to keep investing in the U.S. wireless industry, had been seeking ways to offload T-Mobile USA for at least two years before it settled on the sale to AT&T.

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The Justice Department left open the possibility that the case could still be settled out of court, leading some observers to see the suit as simply a hardball negotiating tactic.

"Our door is open," said Sharis Pozen, the Justice Department's acting antitrust chief. "If they want to resolve those concerns, we can certainly do that."

But another Justice Department official played down the idea of a negotiated deal. "This is not a tactical move," this official said.

Even if negotiations resume, some antitrust experts said it was hard to imagine what the company could offer the government to resolve the concerns outlined in its suit. In its complaint, the government said the transaction would substantially lessen competition in 97 of the nation's top 100 wireless markets.

"The DOJ did not file this complaint to negotiate," said Dana Frix, a partner at Chadbourne & Parke LLP's Washington office, who is not representing anyone in the case. "For future mergers, this complaint shows a tougher DOJ stance. They are sending a big message."

The Justice Department sued to block AT&T's proposed $39 billion takeover of T-Mobile. Bloomberg News

Both AT&T and T-Mobile were expecting to have to offer major concessions and divestitures, but had internally put the probability of the deal clearing at between 65% and 75%, people familiar with the matter said. That probability now falls to about 25%, one person said.

It's not unusual for the Justice Department to file a lawsuit to block a merger since that is its only means of stopping a deal. Sometimes, parties will surrender when they think they won't survive a court challenge, as when Nasdaq withdrew its deal to acquire NYSE Euronext earlier this year. In other cases, companies and the government agree on remedies to address competitive concerns, and a lawsuit and settlement are announced at the same time.

The Justice Department is currently reviewing a range of other deals, including Google Inc.'s purchases of Internet advertising company Admeld Inc. and cellphone maker Motorola Mobility Inc.

The Federal Communications Commission said its separate review of the T-Mobile deal isn't complete, but Chairman Julius Genachowski said Wednesday his agency also has "serious concerns" about the deal's impact on competition.

The Justice Department is suing to block AT&T's proposed takeover of T-Mobile, saying that the combination would hurt competition. Plus: Sprint shares trade up on the news. Tom Catan and Ina Fried discuss on digits.

If the government succeeds in quashing AT&T's bid, many telecommunications-industry bankers said they expected Sprint and Deutsche Telekom to revisit merger plans for a combination of Sprint and T-Mobile USA. Deutsche Telekom could also try to shop the U.S. company to another technology player such as a cable or satellite company.

If AT&T misread the tea leaves, it wasn't for lack of advisers. In addition to three law firms and three banks that initially worked on the deal, the company also hired two additional law firms and two consultants to help with regulatory advice, according to Capital IQ. It also hired a fourth bank to work on potential asset divestitures, people familiar with the matter said earlier.

The government's challenge represents one of the most significant setbacks so far for AT&T chief executive Randall Stephenson, who made a huge bet on a risky deal and now must figure out a Plan B.

The Justice Department moved quickly with its suit to prevent T-Mobile's business from decaying further as it sat in limbo, the department official said.

WSJ's Martin Peers looks at issues that may cause the U.S. Department of Justice to block the proposed merger between AT&T and T-Mobile. Photo: Etienne FRANCHI/AFP/Getty Images

Regulators signaled from the start that the deal raised significant competitive questions, but many investors thought AT&T would be able to overcome their doubts. In Washington, AT&T fired up its formidable lobbying machine, rolling out dozens of interest groups in support of the deal, from large labor unions such as the AFL-CIO to small outfits such as the National Conference of Puerto Rican Women. It also won the support of Facebook and Microsoft Corp.

AT&T and T-Mobile had argued that they didn't compete head-to-head for the same segment of the market, so their combination wouldn't reduce competition.

On Wednesday, the Justice Department rejected that argument, saying that AT&T felt major competitive pressure from T-Mobile.

It quoted internal documents in which T-Mobile described itself as "the No. 1 value challenger of the established big guys" and said its strategy was to "attack incumbents by being faster, more agile and scrappy."

The Justice Department's Ms. Pozen said, "Taking out an innovator, a value pricer like T-Mobile, caused us concern."

—Anupreeta Das, Amy Schatz and Brent Kendallcontributed to this article.

Write to Thomas Catan at thomas.catan@wsj.com and Brent Kendall at brent.kendall@dowjones.com

Corrections & Amplifications

The Federal Trade Commission is reviewing the proposed $29.1 billion merger between U.S. pharmacy benefit managers Express Scripts Inc. and Medco Health Solutions Inc. An earlier version of this article incorrectly said the Justice Department was conducting a review of the deal.