LONDON, Oct 23 (Reuters) - Italy's government and UniCredit are preparing to call off negotiations over the sale of ailing bank Monte dei Paschi (MPS) after efforts to reach an agreement over a costly recapitalization plan fell through, sources told Reuters.

Rome has decided it won't be able to meet UniCredit's requests for a recapitalization package worth more than 7 billion euros as this would make a deal "too punitive" for the Italian taxpayer, one of the sources said.

The decision makes it harder for Prime Minister Mario Draghi's government to meet pledges to EU regulators to re-privatise the bank by mid-2022.

This means Rome will have to negotiate a green light from Brussels to pump more state money into MPS to fill a 2.5 billion euro shortfall while a new agreement with European authorities over Italy's exit is found.

UniCredit and the Treasury declined to comment.

UniCredit had started discussing a possible purchase of Monte dei Paschi under previous CEO Jean Pierre Mustier, immediately calling for a neutral impact on its capital buffers.

But new boss Andrea Orcel, who took over in April, raised the bar, targeting a deal for only the most profitable parts of the bank and seeking an overall recapitalization package in excess of 7 billion euros.

Disagreements recently resurfaced over the assets to be sold, with Rome pushing to include MPS' capital services arm and its leasing and factoring units, two sources had said.

On top of that, negotiators haggled over the way UniCredit calculated its fair value adjustments on MPS liabilities, which became another major stumbling block along with the size and costs of job cuts that Italy had to provide for, the first source said.

"No deal is possible under UniCredit's conditions right now. But the same framework that was offered to UniCredit could be applied to a standalone plan," he said.

Rome has already reviewed the possible benefits of a standalone strategy, which would see the Treasury implementing parts of the measures agreed with UniCredit, including a capital increase worth several billion of euros, this source said.

If the standalone plan goes ahead, MPS will also be rid of toxic debt - which is set to be trasferred to state-owned firm Amco - and its legal proceedings will be carved out and guaranteed by the government, he said. (Additional reporting by Giuseppe Fonte in Rome Editing by Frances Kerry)