The European Commission said it was stepping up preparations for a messy end to Britain's departure from the EU, and that London would be committing "an extremely serious violation" of last year's Withdrawal Agreement if it went ahead with proposed legislation.
After emergency talks between Commission Vice President Maros Sefcovic and Britain's Brexit supremo Michael Gove, the EU said Britain's proposal had "seriously damaged trust" which London must now take steps to re-establish.
Gove, one of Johnson's most senior ministers, said he refused the EU's request to scrap the draft legislation.
"I explained to Vice President Sefcovic that we could not and would not do that," Gove said.
EU diplomats and officials said the bloc could take legal action against Britain, though there would be no resolution before the end-of-year deadline for Britain's full exit.
Britain signed the treaty and formally left the EU in January after more than three years of crises and wrangling over Brexit. But it is a member in everything but name until the end of the year when a transition agreement expires.
The British government says it is committed to the treaty and that a proposed law overriding parts of the Withdrawal Agreement merely clarifies ambiguities. Its main priority, it says, is the 1998 Northern Irish peace deal that ended decades of violence.
French Foreign Minister Jean-Yves Le Drian told his British counterpart Dominic Raab a violation of the Withdrawal Agreement with the EU would be "unacceptable", a spokeswoman said.
Europe's leaders have been handed an ultimatum: accept the treaty breach or prepare for a messy divorce that could sow chaos through supply chains across Europe and spook global financial markets.
The pound fell against the dollar and the euro and the FTSE 100 share index fell. European Central Bank chief Christine Lagarde said she was monitoring Brexit developments.
The EU's negotiator Michel Barnier, in London for separate scheduled talks on an overarching future relationship deal, criticised the British approach to negotiations and said significant differences remained.
"The UK has not engaged in a reciprocal way on fundamental EU principles and interests," he said in a statement.
"The EU is intensifying its preparedness work to be ready for all scenarios on 1 January 2021."
Britain's negotiator David Frost said there would be further talks in Brussels next week and he would keep working on a deal.
"A number of challenging areas remain and the divergences on some are still significant," Frost said in a statement.
European diplomats said Britain was playing a game of Brexit "chicken", threatening to wreck the process and challenging Brussels to change course. Some fear Johnson views a no-deal exit as a useful distraction from the coronavirus pandemic.
One EU source said Britain would not succeed if it tried to use the planned breach of the Withdrawal Agreement as a threat to extract concessions from the bloc in trade talks.
"If they try to do that, it will fail," the EU source said.
Goldman Sachs said it expected "the perceived probability of a breakdown in negotiations to escalate over the coming weeks" but its base case remains a "thin" free trade agreement that steers both sides back from the brink.
Without a trade agreement, nearly $1 trillion in trade between the EU and Britain could be thrown into confusion at the start of 2021, compounding the economic impact of the coronavirus pandemic.
But Britain is pressing one of the EU's most sensitive buttons -- fear that a post-Brexit Britain could become a much more deregulated free-market competitor with access to EU markets by using selective state aid.
The latest dispute centres on rules for Northern Ireland, which shares a land border with EU member Ireland, because under the divorce deal it remains within the EU's orbit -- a restriction Britain wants to remove.
Former British leaders Theresa May and John Major scolded Johnson for considering an intentional breach of international law.
U.S. House of Representatives Speaker Nancy Pelosi said Britain would not get a trade deal with the United States if it did anything to undermine the 1998 Northern Irish peace deal.
"This news comes to us ... that the UK had decided to undermine the Good Friday Accords. What were they thinking?" she told reporters in Washington.
"Whatever it is, I hope they're not thinking of a UK-U.S. bilateral trade agreement to make up for what they might lose."
(Writing by Guy Faulconbridge; Additional reporting by Elizabeth Piper, Michael Holden, Andy Bruce and Olga Cotaga in London, Padraic Halpin in Dublin and John Chalmers in Brussels; Editing by Catherine Evans, Janet Lawrence and David Evans)
By William James and Gabriela Baczynska