Hungary and Poland have blocked approval of the EU’s budget over a clause that ties EU funding with adherence to the rule of law.
The financial package includes €750bn for a coronavirus recovery fund.
Ambassadors of the 27 member states meeting in Brussels were unable to endorse the budget because the two countries vetoed it.
Hungary and Poland have been criticised for violating democratic standards enshrined in the EU’s founding treaty.
The EU is currently investigating both countries for undermining the independence of courts, media and non-governmental organisations. The clause threatens to cost them billions of euros in EU funding.
EU states had already agreed on the €1.1tn (£987bn; $1.3tn) budget for 2021-2027, and the coronavirus stimulus package after a marathon four-day summit in July.
Ambassadors had voted through the clause that made access to EU funds conditional on adherence to the rule of law, because it only required a qualified majority, the German EU presidency said.
But the budget and the rescue package needed unanimous support and were then blocked by Poland and Hungary.
“We cannot support the plan in its present form to tie rule of law criteria to budget decisions,” said Zoltan Kovacs, a spokesman for Hungarian Prime Minister Viktor Orban.
Polish Prime Minister Mateusz Morawiecki threatened a veto last week.
On Monday, Polish Justice Minister Zbigniew Ziobro said the rule of law issue was “just a pretext”.
“It is really an institutional, political enslavement, a radical limitation of sovereignty,” he said.
But Austrian Chancellor Sebastian Kurz, addressing a conference shortly after the budget was blocked, said that “upholding the principles of the rule of law is an absolute necessity” because the sums being handed out by the EU to member states were so vast.
German ambassador Michael Clauss, who chaired the meeting, warned that the EU would face “a serious crisis” if the financial package was not quickly adopted.
“We have already lost a lot of time in view of the second pandemic wave and the severe economic damage,” he said.
In a tweet, Johannes Hahn, EU-Commissioner for Budget and Administration, said he was “disappointed” by the veto.
He urged member states to “assume political responsibility and take the necessary steps to finalise the entire package”.
“This is not about ideologies but about help for our citizens in the worst crisis since World War Two,” he added.
The impasse will be debated by EU European affairs ministers on Tuesday and by EU leaders in a video-conference on Thursday. However, officials say a solution might take longer to find.