LONDON -- Although the auction for the U.K.'s third-generation mobile phone licenses may be over, confirmation that Spain's

Telefonica

(TEF) - Get Report

and the Netherlands'

KPN

(KPN)

are in talks about a possible merger further illustrates that the battle for

Orange

and the 3-G license it owns is just getting interesting.

Vodafone AirTouch

(VOD) - Get Report

must dispose of Orange to gain regulatory approval of its merger with Germany's

Mannesman

. Although Orange's Chief Executive Hans Snook favors a de-merger of his firm, it is looking increasing likely that Vodafone will opt for a trade-sale as a way of cutting its high debt burden and build a war chest to pursue third-generation mobile licenses across Europe.

There are likely to be several interested parties in Orange. However, the two front-runners,

France Telecom

(FTE)

and Telefonica -- both submitted failed bids in the U.K. auction for the 3-G licenses -- are now looking with envy at the license Orange has managed to secure with a bid of

4.1 billion ($6.5 billion).

Certainly, Orange won't come cheap and a merger with KPN would give Telefonica more economic muscle in a two-way race with France Telecom for the Orange prize.

"If you think Orange could be worth 50 billion euros and KPN has a market capitalization of 57 billion euros, then

together they would be in a much stronger position," argues Tim Hirst, an analyst at

Salomon Smith Barney

.

Investors like the idea of what would be the first cross-border union between two of Europe's former monopolistic carriers. Europe was closed Monday when the rumors of a possible merger first began to circulate, but the ADRs of Telefonica and KPN soared 6.0% and 9.6%, respectively. In European trading on Tuesday, Telefonica closed up at 26.70 euros, and KPN up at 11.6% at 125.00 euros.

Based on Monday's closing prices, the market cap of the combined entity would be 153 billion euros -- of which Telefonica would represent 62%. Combined, KPN and Telefonica would have more mobile subscribers than Vodafone, although in terms of market cap it would place fourth in Europe, behind Vodafone,

Deutsche Telekom

(DT) - Get Report

and France Telecom.

While a full-scale merger is being discussed, one person with knowledge of the talks cautioned that there were still significant issues to be resolved before a deal can be agreed upon and it is possible that an alliance might be restricted to a strategic agreement covering their mobile and Internet businesses.

"They are working toward a full-blown merger, but you have to leave room for something less than that, or even nothing at all coming out of these talks," the source said.

Indeed, it is understood that KPN had been in talks with

NTT DoCoMo

, the Japanese wireless carrier, which would have led to a mobile services alliance between the two.

Discussions with the Japanese company are understood to have led KPN to suspend its plans for an initial public offering of its own wireless business last week. While DoCoMo has been left on the sidelines -- for now -- by KPN's negotiations with Telefonica, it could still have a role to play in a future wireless alliance, one person close to the companies said.

Outside of the money matter, Telefonica's relationship with Orange is growing through their membership in a consortium that is bidding for one of the third-generation mobile licenses in Germany. Telefonica owns 40% of the consortium and Finland's

Sonera

and Orange own the other 60%.

However, while Telefonica may be growing closer to Orange, it should be remembered that it is Vodafone that has the final say over to whom Orange, and its precious 3-G license, will be sold.

As originally published, this story contained an error. Please see

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