The collapse of negotiations leaves both companies at odds with changes in the industry. Fiat Chrysler is the seventh-largest carmaker worldwide, and Renault is the eighth. Their relatively small size makes them vulnerable as the auto industry tries a costly and uncertain transition to electric cars and vehicles loaded with driver-assistance features.

[Read more about the challenges automakers face.]

And neither Renault nor Fiat Chrysler has a strong presence in China, the world’s largest car market and one of the few regions still seen as having potential for growth.

The merger mess may have other repercussions. Renault’s chief executive, Jean-Dominique Senard, who worked with Mr. Elkann to sort through the proposal, had the backing of most of the board but was blindsided by the government’s last demand. With the deal scuppered, Mr. Senard must weigh how effective he can be at Renault, according to the people with knowledge of the situation.

The proposed deal was first revealed by Fiat a week ago. After two days of talks this week, Renault had tentatively scheduled a news conference for Thursday morning to announce an agreement.

But the French government is Renault’s largest shareholder, and has a seat on the company’s board. As talks progressed, according to two people familiar with Fiat Chrysler, the French government tried to micromanage the process.