David Cameron has been dealt a major blow after Angela Merkel and François Hollande snubbed a special UK exercise to assess the impact of EU laws and regulations on Britain and the rest of Europe.

In a sign of the prime minister's growing isolation in Europe after his decision to promise a referendum on Britain's membership of the European Union, Paris and Berlin have decided jointly to boycott the British "balance of competences" review.

The decision by France and Germany is a particular setback to Cameron, who said in his long-awaited speech on the EU in January that nothing should be off the table in the review, which will examine every area of EU lawmaking.

In an attempt to show it has an open-minded approach, Britain sent letters to the other 26 EU members asking for their thoughts on the impact of EU laws in areas ranging from the single market to the environment. The letters, dubbed questionnaires in Paris and Berlin, were sent after William Hague, the foreign secretary, launched the review last July. It will report in stages from this summer.

But France and Germany, who form the EU's "big three" with the UK, have decided to steer clear of the review because they see it as driven by British politics. A French diplomat said: "This is a British domestic political exercise. We have therefore decided we would not participate."

It is understood that only a few EU countries have replied to the letters. These include Italy, run until recently by Mario Monti's technocratic government, and Sweden, whose centre-right prime minister, Fredrik Reinfeldt, is Cameron's closest ally in the EU.

The boycott by France and Germany, which went to the trouble of co-ordinating their positions at senior levels, will disappoint Cameron, who set great store by the decision of Merkel to give a guarded welcome to his EU speech.

Berlin's decision to ignore the British "balance of competences" review follows a clear private warning from Merkel that, if re-elected in September, she would grant little of substance to Cameron in his demands for a renegotiation of the terms of Britain's EU membership before the UK's referendum, which the prime minister has said would be held by 2017 at the latest. Hollande has been publicly dismissive of Cameron's speech.

The Tories plan to use the review to help them decide on which areas to renegotiate. Cameron showed the importance of the exercise in his speech announcing the referendum in January when he said: "Our balance of competences review [will] give us an informed and objective analysis of where the EU helps and where it hampers."

Whitehall sources are putting a brave face on the Franco-German snub. One senior figure said: "It is shrug your shoulders time. We are not put-out."

A government spokesperson said: "This is intended to be an open and transparent process so of course we have invited other EU countries to contribute, and indeed several have along with a number of international organisations, but we recognise others consider this an essentially domestic review and have decided not to so far.

"Ultimately, the analysis will be focused on what the EU means for the UK and our national interest so our priority is the British audience and we've had a good response from stakeholders here so far.

"Of course, we're regularly working with our European partners to reform the EU to make it more competitive, for example at the last summit the PM worked with Hollande and Merkel to secure agreement that the EU will identify areas where it an withdraw legislation that is no longer necessary."

The Franco-German decision shows how Britain has become increasingly isolated in Europe after the prime minister's speech in January. The foreign secretary had high hopes of co-operation from across the EU for his review when he launched the exercise last July in a statement to MPs.

Hague said: "The review will be an outward-facing exercise, both domestically and internationally."

The boycott will come as something of a disappointment to ministers because British diplomats across the EU have gone out of their way to stress that the exercise will be conducted in an even-handed way. Civil servants will submit reports to a three-strong ministerial team chaired by David Lidington, the Europe minister, which also includes Mark Hoban, the work and pensions minister, and Lord Wallace of Saltaire, the Liberal Democrat whip and European affairs academic who is the party's representative in the Foreign Office.

The senior Whitehall source said: "The team is carefully balanced. William Wallace taught half the foreign ministers in Europe. His wife [European affairs academic Dame Helen Rushworth] taught the other half."

The ministers are due to receive the drafts of the first six reports within weeks. These cover the internal market, foreign policy, development co-operation and humanitarian aid, taxation, health, animal health and welfare and food safety.

Lidington and his team will assess the reports and could ask for them to be rewritten if they are written in EU jargon. "We don't want the language of the Berlaymont," one source said, referring to the name of the Brussels headquarters of the European commission. Once the ministerial team have approved the reports, they will then be sent to the European affairs committee of the cabinet.

The senior Whitehall source said: "The letters explained our approach and said we would welcome contributions. It was important to show that this is not about putting together a list of demands that form a path to the exit route."

The review was set up in the coalition agreement after the Lib Dems blocked the Tories from repatriating social and employment laws from the EU. The reports will not make policy proposals but will instead summarise evidence submitted. Each coalition party will be free to use the reports to draw its own conclusions.