CORRECTED-UPDATE 1-Sterling extends losses as EU launches legal case against UK

(In paragraph six, corrects sterling rate to $1.2841 from $1.841, adding dropped number)

LONDON, Oct 1 (Reuters) - Sterling fell against the dollar and the euro on Thursday after a report that Britain and the EU were still far apart on the key issue of state aid in Brexit trade talks, and it was also hit by the EU launching its legal case against the UK

British and EU trade negotiators have failed to close the gap on state aid rules, an issue which is preventing them from reaching an agreement on post-Brexit trading rules, officials and diplomatic sources said.

Britain said there are still differences between the two sides in negotiations, but that London will work hard to try to secure a deal.

The EU on Thursday launched a legal case against Britain over its new Internal Market Bill that undercuts London’s earlier legal commitments under its Brexit divorce treaty.

The pound, which had started the day slightly up against a weaker dollar, fell on the news that the EU and UK were still far apart.

At 0906 GMT, sterling was down 0.6% versus the dollar at $1.2841. It was also down around 0.5% versus the euro at 91.28 pence per euro.

A gauge of sterling overnight volatility rose to its highest since March.

“I suggest there is further downside ahead for the pound on this news,” said Neil Jones, head of FX sales at Mizuho, who said sterling could retreat towards $1.27.

“A no-deal is looking more likely than expectations over the last couple of weeks as sentiment in favour a deal was shaping up nicely,” he said.

“These headlines do elevate concerns,” he added.

This week’s round of Brexit talks is the last scheduled so far and EU leaders will again assess progress on Oct. 15-16.

Banks have raised their forecast for the likelihood of the UK leaving the single market and customs union without a trade deal when the status quo transition period ends on Dec. 31.

Trade negotiations were thrown into disarray last month by the UK’s Internal Markets Bill, which would breach the EU Withdrawal Agreement signed in January.

Britain’s lower house of parliament approved the Internal Market Bill on Tuesday and it is now with the House of Lords.

“It looks like Boris Johnson is continuing to lay the groundwork for a no-deal Brexit, so at this point the actual sticking points of the negotiation, whether it be state aid or the Northern Irish border questions are largely redundant,” said John Woolfitt, director of trading at Atlantic Capital Markets.

“At this point we are simply waiting to see just how messy the hard Brexit will be,” he added.

Brexit concerns ensured that British government bond yields were the only ones to buck the broader trend of a general rise in European government debt. Yields across the curve were flat to a touch lower.

Reporting by Elizabeth Howcroft, additional reporting by Thyagaraju Adinarayan; editing by Simon Jessop and Jane Merriman