Germany and France have unveiled radical and divisive new proposals to put the euro on a new footing and settle the EU's worst ever crisis. If agreed, the Franco-German pact will entrench a new era of two-speed Europe, making the eurozone the centre of policy-and decision-making in the EU and complicating David Cameron's balancing act on Europe.

Before a crucial two-day summit starting in Brussels on Thursday evening, billed as the last chance to save the euro, the German chancellor, Angela Merkel, and the French president, Nicolas Sarkozy, outlined their vision for European reform in a letter to Herman Van Rompuy, the president of the European council chairing the summit.

As well as demanding a new euro rulebook aimed at establishing "fiscal union" among the 17 eurozone countries, Merkel and Sarkozy said the eurogroup's 17 leaders would hold monthly summits during the crisis, and install a permanent president of the eurogroup as well as a ministerial structure to run the body.

They called for a new legal framework enabling the group to forge ahead with a financial transaction – or Tobin – tax that is fiercely opposed by the Cameron government, and to proceed on common policies on financial regulation, labour market policy, corporation tax principles, and a "more efficient" use of the EU budget in the eurozone.

In line with their summit in Paris on Monday, Merkel and Sarkozy also called for EU treaties to be reopened and changed to write new rules for the euro, giving the European commission and the European court of justice extensive new powers of intervention in member states' budgets. "We are convinced that we have to act immediately," they said.

The summit has to take decisions so that the treaty changes are tabled by next March. But if it proves too difficult to reach agreement among the 27 EU states, Berlin and Paris said they would opt for a new pact simply among the euro countries.

"We propose that those new rules and commitments should be enshrined in European treaties. Alternatively, the member states whose currency is the euro will have to go ahead."

That was seen as a warning to Cameron to temper his demands and go along with changing the Lisbon treaty or be bypassed.

Every euro country is to enact new balanced budget legislation, with the European court of justice empowered to rule whether the new laws are adequate, the two leaders demanded. The euro rule requiring budget deficits to be less than 3% of GDP is to be drastically strengthened with quasi-automatic penalties for those who break the rule, they added.

"A sequence of interventions of increasing intensity into euro area member states' rights should be allowed as a focussed response to continued infringement. Steps and sanctions proposed or recommended by the European commission should be adopted unless a qualified majority of the euro area member states decides otherwise."

Senior officials from all 27 EU countries were locked in high-stakes negotiations over the Franco-German demands, and over how to arrest the collapse of the euro by ringfencing the risk of sovereign debt contagion and establishing a storm-proof regime for the single currency.

Proposals from Van Rompuy aimed at installing a new regime without renegotiating EU treaties were roundly rejected by Berlin. In a paper outlining the eurozone's options discussed by three top officials from each of the EU's 27 countries, Van Rompuy proposed exploiting arcane protocols in the Lisbon treaty to stiffen the euro rulebook without reopening the treaty. Senior EU diplomats said Van Rompuy's gambit, only conjured up in the past 72 hours, was gaining momentum as it would facilitate swifter action and avoid acrimonious negotiations, parliamentary ratifications, and possible risky referendums in Ireland and Austria.

But a senior German official dismissed the proposal as a "typical Brussels box of tricks" that would not pass muster with Merkel. Hinting at a showdown at Thursday's summit, the German official said many of the governments inside and outside the eurozone failed to appreciate "the seriousness of the situation".

Germany, he said, would not stand for "rotten, more rotten or even worse compromises. I am more pessimistic than I was last week that there will be an overall agreement."

The German hard line may have been an exercise in managing expectations of a summit billed as yet another last chance to save the euro and put two years of deepening crisis in the EU behind it. But on several key points proposed by Van Rompuy, the Germans flatly said no. For example, Van Rompuy proposed that the bailout fund "have itself the necessary features of a credit institution", but Berlin said it could not receive a banking licence enabling it to tap funds from the European Central Bank.

Berlin also rejected notions being floated in Brussels that the current temporary bailout fund and the new permanent fund that is being established next year be allowed to run concurrently and in parallel to boost the available firepower to almost a trillion euros. The permanent fund or European Stability Mechanism, funded to the tune of €500bn, was the limit, the official said.

The sense of isolation enveloping Cameron was compounded when Merkel and Sarkozy summoned talks among the "Frankfurt Group" in advance of the summit. The group includes the new European Central Bank president, Mario Draghi, the chairman of the eurogroup, Jean-Claude Juncker, the European commission chairman, José Manuel Barroso, and the EU economic affairs commissioner, Olli Rehn. They will meet Van Rompuy before the other 25 EU leaders sit down for a dinner devoted to resolving the debt crisis – and while Cameron holds talks with Mario Monti, Italy's new technocrat premier.

The "Frankfurt Group", set up at a farewell dinner in the German financial capital for Jean-Claude Trichet after eight years as ECB president, normally includes Christine Lagarde, IMF managing director, as well. It has been sharply criticised by other EU countries, including hard core members of the eurozone, for its lack of accountability and for acting like an unelected, undemocratic directorate for running Europe.

Draghi will attend the talks just hours after the ECB is expected to trim interest rates by a further 25 basis points to 1% and indicate that it is prepared to extend longer loans to commercial banks suffering from frozen inter-bank lending.

The banks will on Thursday set strict new targets for raising fresh capital and meeting 9% ratios by the European Banking Authority.

In October it said Europe's biggest banks needed to raise €106.5bn to deepen their buffers; now some analysts are suggesting that up to €300bn could be required because of worsening losses on exposure to sovereign debt holdings they are being forced to write down. German banks alone may need more than €10bn extra.

Draghi, chairing only his second ECB governing council meeting, has dropped strong hints in recent days that the eurozone central bank could substantially increase purchase of distressed sovereign bonds – and keep yields down – if the summit agrees to a "new fiscal compact."

The ECB is already under severe pressure to ease the pressure on Europe's banks because of mounting evidence that the continent faces at best a recession and at worst a slump, with rising unemployment and factory closures. Banks are finding it harder to borrow capital from each other, with loans to the "real economy" in the trough. The suggestion now is that the ECB will allow banks to borrow from it over two to three years rather than the maximum year as of now.