A deal, which the official said could be announced by next week, would be the first since the government relaxed ownership rules in September to allow foreign airlines to invest up to 49 percent in a domestic carrier.

"Etihad has not yet decided. They are talking to both," said the officials, who has knowledge of the talks but declined to be named as the negotiations are confidential.

Buying into Jet is seen as more lucrative for Etihad as the two carriers already have a code-sharing agreement and could target the market share of state-owned Air India and Dubai-based Emirates Airline , which dominates routes between India and the Middle East.

But a stake in Kingfisher, which has been grounded after its licences were suspended and whose owner, liquor baron Vijay Mallya, has been looking for an investor for more than a year, would be cheaper.

Indian carriers are beset by stiff competition and high operating costs and have been in talks to sell minority stakes to foreign operators.

Shares in Jet Airways Ltd, the No. 2 Indian carrier, closed 2.4 percent higher on Monday, after rising as much as 4.7 percent to a nearly two-year high, on hopes that Abu Dhabi-based Etihad would strike a deal with it.

Kingfisher shares ended down 5 percent - their daily limit - snapping nine consecutive sessions of gains.

"Unbelievable as it might sound, Kingfisher at the moment stands a better chance, but the price has to be right," said Rajan Mehra, an industry expert and the India head of U.S.-based private jet operator Universal Aviation.

"Etihad will be able to have control over the airline. Right now what they want is control," said Mehra, who previously headed Qatar Airways' India operations.

Kingfisher is considering giving up operational control of its overseas flights if a deal goes through, a separate source had said earlier.

The debt-laden carrier said last week it was in talks with Etihad and other investors about taking a stake, while later in the week it capped foreign portfolio investment in the company at 3 percent, carving space for a foreign investor to buy as much as 49 percent in it.

On Monday, Kingfisher said it was looking to restart operations and would arrange funding itself. The carrier said it would discuss a full recapitalisation plan with a small group of bankers.

Kingfisher will need about 4.25 billion rupees to restart according to its plan, said Shyamal Acharya, a deputy managing director at State Bank of India (SBI.NS), the country's top lender and the lead bank to Kingfisher. (Additional reporting by Swati Pandey in MUMBAI; Writing by Devidutta Tripathy; Editing by David Cowell)

• A Permanent Economic Emergency