The two sides have come to an impasse over demands by Swiss commodities trader Glencore, which holds a 35 percent stake in Xstrata, for an expansion of marketing rights in the combined firm, said the source, who declined to be named.
Glencore has a string of lucrative long-term contracts to sell a large portion of Xstrata's mining output and wanted further scope if Vale bought the firm, he added.
"They're a long way apart. If that's not resolved, there really isn't anything to talk about," the source said.
Negotiations have veered away from price, which previously had been a sticking point. The two sides are more or less happy with a price around 45 pounds, he added.
Vale, the world's largest iron ore producer, said on Jan. 21 that it was in talks to possibly buy Xstrata, which is based in Swizerland but listed in London.
A marriage of the two companies would diversify Vale from dependence on iron ore by boosting its presence in copper and nickel. The combined business would be the world's largest nickel producer, surpassing Russia's Norilsk Nickel.
Vale has secured loans of an estimated $50 billion from a pool of about eight banks -- including Santander, HSBC, BNP Paribas, Lehman Brothers, Credit Suisse, Citigroup, Calyon and Royal Bank of Scotland, a source close to the financing has told Reuters.
Last week, Vale secured agreements with Asian and European steelmakers to raise its iron ore prices by 65 percent from 2007.
Iron ore accounts for 40 percent of Vale's cash flow. Analysts estimate that the increase in ore prices would result in an additional $10 billion of annual revenue for Vale.
Vale is due to post results after the market close on Thursday, but the source the firm is not expected to comment on the takeover talks.
Xstrata is due to post results on Monday.