Hopes of a diplomatic breakthrough over Iran's nuclear programme were dwindling tonight after Tehran demanded changes to a uranium exchange deal that European diplomats described as "unacceptable".

If the deal collapses, as seems likely, it would deliver another critical blow to Barack Obama's policy of engagement, and put international sanctions and Israeli military action back on the table.

The uranium deal, agreed in principle in Geneva at the beginning of the month, involved Iran shipping out most of its enriched uranium and, in return, being provided about a year later with fuel rods for its research reactor in Tehran.

Iran's response, delivered after a week's delay to the International Atomic Energy Agency (IAEA), was not made public, but according to diplomats familiar with the details, Tehran demanded two big changes: Iran would only ship its uranium out in batches, and only when the French-made fuel rods were delivered.

That would remove the element of the deal that made it attractive to the west: the temporary removal of most of Iran's enriched uranium, which is currently enough to make a nuclear weapon. Iran says its nuclear programme is peaceful.

"This is completely unacceptable," said a European diplomat, who said discussions were under way in Brussels tonight to formulate a common response. "They want to keep all the gains and give nothing away," another diplomat said.

In public comments earlier Mahmoud Ahmadinejad, Iran's president, gave the impression that progress was being made. In a speech in the Iranian city of Mashhad, he said Iran was ready to cooperate, but not at any cost: "If you stretch your hand towards us honestly, we will press it. But if there is any conspiracy, Iran's nation will respond in the same way as it did to Bush and his likes."

The other parties to the talks on the uranium exchange deal – the US, Russia and France – had confirmed their readiness to abide by the agreement, which would have involved shipping 1,200 kg of Iran's low enriched uranium to Russia for further enrichment, and then to France to make the fuel rods, which would be used in the Tehran research reactor for medical purposes. The US would upgrade equipment at the Tehran reactor.

Iranian officials had taken part in talks about details in Vienna last week, but then asked for more time for Tehran to consider the deal. Tehran's response was delayed six days, due to apparent uncertainty within the regime. The IAEA issued a cautious statement today calling Iran's proposals an "initial response", and adding that the agency's director, Mohamed ElBaradei, was talking to all parties "with the hope that agreement on his proposal can be reached soon".

European leaders are due to hold talks with the Obama administration on the next steps on Tuesday, when Angela Merkel and the EU foreign policy representative, Javier Solana, are both due in Washington.

One possible compromise being contemplated tonight was for Tehran to put its enriched uranium in a secure site on Iranian soil, but under IAEA surveillance, until the fuel rods were ready for delivery. But there appeared to be no workable compromise to Iran's insistence on handing over the uranium in smaller batches.

Iran has also backed away from another undertaking made in Geneva, to meet before the end of the month to discuss its continued enrichment of uranium in defiance of UN security council resolutions.

The uranium exchange deal and Tehran's apparent willingness to negotiate over its enrichment programme were seen as important diplomatic gains in Geneva after nearly four years of stalemate.

If the US and its allies decide that negotiations have run their course, they will begin to push for fresh UN sanctions at the security council. European diplomats said tonight it would also become difficult to convince Israel that diplomacy was making progress.