Combining Idea Cellular and Vodafone India would create a company with 390m subscribers. The largest mobile phone company in the world is state-backed China Mobile with 835m customers.
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The FTSE 100 firm said in a short statement that Idea Cellular would issue new shares to Vodafone to pay for its Indian arm. Ultimately, this "would result in Vodafone deconsolidating Vodafone India".
Vodafone's shares gained three per cent in the wake of the news in early trading before ending the day up over one per cent.
The Indian mobile phone market has come under increasing pressure with the entry last year of Jio, backed by India's second largest listed firm Reliance Industries, which has offered Indian customers a cut price alternative.
Vodafone had previously been eyeing-up a float of its Indian operations. It subsequently shelved the plans prompting reports that it was in merger talks with Idea Cellular last August.
As Vodafone struggled to crack the Indian market it was forced to make a painful $5bn (£4bn) writedown of its investment in India. Neil Shelton, an analyst at Morgan Stanley said India has been the "biggest drag" on Vodafone's share price since October last year.
And Jerry Dellis, an analyst at Jefferies said news of the talks was positive for shareholders. He added: "A merged entity with greater scale should be better-placed to compete with Jio on price, creating scale efficiencies to offset ongoing price deflation."
Vodafone said its in interest in Indus Towers would not be included in the deal. It has a 42 per cent shareholding in Indus Towers, a joint venture with the Bharti Airtel – India's largest mobile operator – and Idea Cellular.