The Competition and Markets Authority (CMA) said, PayPal had not resolved concerns about how the deal, PayPal's biggest ever, could hurt competition and lead to higher prices, or a lower quality service, for customers in the UK mobile payments market.
The regulator has also flagged concerns the merger could damage competition in the emerging market for "omni-channel" payment services, or single payment processing platforms that can work across all sales channels and devices.
PayPal is working with the CMA and is committed to demonstrating the market is, and will remain, competitive, a company spokesman said.
The acquisition, which would allow the U.S. payments processor to expand into the retail payment terminals business in international markets, closed in September.
The deal will now be examined by a CMA-appointed inquiry body, with a final decision due by May 21, the CMA said.
PayPal feels the chances of getting the merger cleared by the inquiry panel are "very good", a source familiar with the matter said.
Founded in 2010, iZettle is one of the largest fintech start-ups to emerge from Europe, and one of a string of successful venture-backed companies to emerge from Sweden in the past decade or more.
(Reporting by Shashwat Awasthi and Noor Zainab Hussain in Bengaluru; Editing by Bernard Orr and Mark Potter)