Loss-making Alitalia was kept running by a government-engineered 500 million euro ($694 million) rescue package last year, but it needs to find a cash-rich partner quickly to revamp its flight network or risk having to ground its fleet.
Abu Dhabi-based Etihad has been looking at Alitalia's books for a possible investment since the start of the year. However, the prospect of large job cuts at Alitalia and the airline's debt of at least 800 million euros have been major hurdles in the talks.
"The position of the Arab group has hardened; some problems have been more markedly underlined than before," one of the sources said.
A government source, however, said that Etihad's tougher position could be overcome. "The government is counting on finding a solution," the source said.
Italian Infrastructure Minister Maurizio Lupi told parliament that Etihad had sent a letter to Alitalia on Wednesday to set out its conditions for a possible investment.
Lupi said it is up to the company's private shareholders - which include Alitalia's creditors Intesa Sanpaolo and UniCredit - to respond.
Italian daily Il Messaggero reported on Thursday that a deal between the two airlines was off because the conditions were not in place, but the sources denied the talks had collapsed.
"It's part of negotiations ... It in no way means the deal is over. They have just put tough conditions on the deal," a United Arab Emirates-based source said.
An Etihad spokesperson declined to comment. Alitalia also declined to comment.
Etihad CEO James Hogan held talks with Prime Minister Matteo Renzi last week. A source with knowledge of the talks said at the time that Etihad was considering investing up to 500 million euros in Alitalia and was inching towards an offer. Out of that investment, 350 million would be for a 49 percent stake in the Italian airline, the source added.
However, the source also said that one of the conditions put forward by the Gulf airline was for 2,000 job cuts out of Alitalia's 14,000-strong workforce. Italian media have reported demands for bigger cuts, with Il Messaggero on Thursday citing 3,000.
"Things are a bit stalled, mainly because of job-related problems. But there's too much at stake ... a solution will be found," another source close to the matter said on Thursday.
Etihad began talks with the Italian airline after disagreement over debt scuppered a potential Alitalia tie-up last year with Air France-KLM, formerly Alitalia's biggest shareholder.
A marriage with Etihad could bring Alitalia the money it needs to invest in a new strategy, focused on long-haul routes, after its struggles to compete against low-cost airlines and high-speed trains on domestic and regional routes.
A stake in Alitalia, which offers access to Europe's fourth-largest travel market and flies 25 million passengers a year, would further Etihad's efforts to expand its global reach through strategic holdings in other airlines.