(Reuters) - A European summit deal to strengthen budget discipline in the euro zone failed to restore financial market confidence on Monday, forcing the European Central Bank to step in again gingerly.

The euro fell, stocks slid and borrowing costs for Italy and Spain rose as investors weighed the outcome of last week's summit that split the European Union, with Britain blocking treaty change and forcing euro zone countries to negotiate a fiscal accord outside the Union.

Friday's initial market rally petered out in less than 24 trading hours due to legal uncertainty surrounding the new pact and the absence of an unlimited financial backstop for the single currency.

French President Nicolas Sarkozy said the legal basis of a new accord to enforce debt and deficit rules in the 17-nation euro area with quasi-automatic sanctions and intrusive powers to reject national budgets would be worked out before Christmas.

"In the next fortnight, we will put together the legal content of our agreement. The aim is to have a treaty by March," Sarkozy told newspaper Le Monde in an interview.

An EU diplomat said the first draft of the new treaty would be ready by early next week. Sarkozy said the aim was to have it ratified by all member states except Britain by June.

"You have to understand this is the birth of a different Europe - the Europe of the euro zone, in which the watchwords will be the convergence of economies, budget rules and fiscal policy. A Europe where we are going to work together on reforms enabling all our countries to be more competitive without renouncing our social model," the French leader said.

In the Le Monde interview, Sarkozy prepared French voters for a possible downgrade of the country's AAA credit rating but insisted he could cut the public deficit without cutting salaries and pensions.

Traders said the ECB intervened to buy short-term Italian debt after yields on Italian and Spanish debt spiked.

The central bank revealed on Monday it had slashed bond purchases in the week before the EU summit as it raised pressure on the bloc's leaders to introduce tighter debt controls and make further public spending cuts. It bought just 635 million euros in bonds in the week to December 9 compared to 3.66 billion the previous week.

ECB sources told Reuters on Friday purchases would remain limited with a maximum ceiling of 20 billion euros a week. There is no prospect of a "big bazooka" to shock markets.

Italian 5-year bond yields shot up above 7 percent, widely seen as a danger level while 10-year yields spiked above 6.8 percent and Spanish 10-year yields topped 6 percent.

Investors' appetite for short-term paper drove Italian one-year borrowing costs down just below 6 percent at an auction but yields remain uncomfortably high.

"Let's not raise expectations too high, there will be more summits," credit ratings agency Standard & Poor's chief European economist Jean-Michel Six said.

"Time is running out and action is needed on both sides of the equation, on the fiscal and monetary side," he told a business conference in Tel Aviv.

S&P has put 14 euro zone governments on watch for a possible rating downgrade in the coming weeks, arguing that the deepening debt crisis and looming recession will increase their potential liabilities and reduce their ability to cope with them.

If some of the euro zone's AAA-rated members are downgraded, it would call into question the solidity of the euro zone's rescue fund, which would likely suffer a similar fate.

"There is probably yet another shock required before everyone in Europe reads from the same page, for instance a major German bank experiencing difficulties in the market," Six said.

POLITICAL FALLOUT

Political aftershocks from Friday's historic rift between Britain and the rest of the 27-nation bloc continued to shake Europe on Monday with Prime Minister David Cameron facing tension in his coalition and doubts in the business community.

Cameron was given a hero's welcome by Euro skeptics in his Conservative party but faced a backlash from his Liberal Democrat coalition allies when he explains a veto that has cast Britain adrift from its continental partners.

"Britain remains a full member of the EU and the events of the last week do nothing to change that," Cameron insisted in parliament.

In a defiant statement, he told lawmakers he made no apology for having demanded safeguards for the City of London financial centre in any new EU treaty, but said Britain's interests remained fully protected by its membership of the single market.

LibDem Deputy Prime Minister Nick Clegg said on Sunday he was "bitterly disappointed" with an outcome that would diminish Britain's global influence and was bad for jobs and business. Clegg was conspicuously absent from parliament during Cameron's address.

In business, the chief executive of the world's largest advertising group, Martin Sorrell of London-based WPP, told Reuters that Britain's interests would be better serviced "inside the EU tent" than on the sidelines. [ID:nWLA9949]

Greek Finance Minister Evangelos Venizelos said his country's talks with international creditors on a second bailout package to avert bankruptcy were "critical and difficult." He said he hoped to wrap up negotiations on a voluntary debt restructuring with private bondholders by the end of January.

In Brussels, officials were groping for a strong legal basis for the planned fiscal compact, with Britain arguing that the euro zone cannot use the EU treaty institutions - the European Commission and the European Court of Justice.

European Economic and Monetary Affairs Commissioner Olli Rehn said most of the practical measures to strengthen budget enforcement could be implemented immediately under a set of rules known as the "six-pack" agreed in October.

"I regret very much that the United Kingdom was not willing to join the new fiscal compact; I regret it as much for the sake of European and its crisis response, as for the sake of British citizens and their perspectives," Rehn told a news conference.

But he added a note of warning to London: "If this move was intended to prevent bankers and financial corporations of the City from being regulated, that's not going to happen. We must all draw the lessons from the ongoing crisis and help to solve it and this goes for the financial sector as well."

The euro area faces the next potential crunch point in mid-January when Italy, which has a debt mountain of 1.9 billion euros or 120 percent of its annual output, has to start issuing tends of billions of euros in bonds towards a 2012 total of 340 billion euros needed to roll over maturing debt.

"We believe Italy is just as vulnerable, if not more, to a self-fulfilling panic in financial markets," said Nicolas Spiro, managing director at Spiro Strategy. "Nothing has been done to allay the growing concerns about Italy's huge funding needs next year."

(Additional reporting by Alexandra Za in Milan, Keith Weir and Sudip Kar-Gupta in London,; Writing by Paul Taylor, editing by Mike Peacock)

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