Deutsche Telekom has ruled out a counter-bid for O2 - currently the subject of an agreed £17.7 bn takeover deal with Spain's Telefonica - sending shares in the British group sharply lower in morning trade.

The German group let it be known today - initially through an interview with Reuters - that it was not interested in trying to gatecrash O2 and Telefonica's deal, which was only unveiled on Monday.

In comments that were subsequently widely confirmed, Karl-Gerhard Eick, Deutsche Telekom's finance director, told the news agency that pursuing O2 "would not be in the interest of our shareholders".

"Deutsche Telekom will not make a counterbid for O2," Mr Eick said.

The move puts paid to the German group's longstanding ambition to strike a deal with O2, which had been consistently at the centre of takeover speculation before the Telefonica offer agreed at the beginning of this week. Deutsche Telekom had originally joined forces with Dutch group KPN to pursue a joint-bid, although the idea eventually collapsed earlier this year.

Shares in O2, which have been trading above the 200p level offered by Telefonica on hopes of an auction, shed more than 5 per cent within the first hour of dealing today, losing 11p to 198.25p.

Analysts had been divided about the likelihood of Deutsche Telekom making a counter-offer, with some speculating the German group would not be prepared to overpay for O2 and would instead cast its eye towards alternative acquisitions.

Telefonica, the world's fifth-largest mobile phones group, said on Monday that taking over O2 would mean it could enter the busy German and British telecoms markets, two of Europe's largest.

The Spanish group said it expected the deal, which should be completed by next January, to enhance its earnings immediately and promised O2 shareholders that they would still receive an interim dividend at the beginning of December.

The offer marked the largest all-cash takeover deal ever in Europe and the second-largest ever worldwide, according to investment banking data and research firm Dealogic.

In terms of size for cash deals it is dwarfed only by last year's takeover of AT&T Wireless Services in the United States by Cingular Wireless, which was worth $46.77 billion, according to Dealogic.

As evidence of the potential benefits of consolidation in the telecoms sector, Telefonica is hoping to generate annual savings of just under £200 million a year by 2008 from the O2 acquisition.

O2, which was part of BT until it was spun off as an independent listed company in 2001, employs 15,000 people and has nearly 25 million customers in Britain, Ireland and Germany. For the financial year to the end of March, it posted pre-tax profits of nearly £1.8 billion on revenues of nearly £6.7 billion.

Management of O2 have recommended the Telefonica deal, which must still gain clearance from the European competition authorities.

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