LONDON/MADRID (Reuters) - Spanish telecoms giant Telefonica agreed on Monday to buy mobile group O2 for 17.7 billion pounds, sparking hopes of a bidding battle for one of the sector's hottest takeover targets.

Financially-powerful Telefonica, the world's fifth-largest telecoms firm by market value, said it would pay 200 pence per share in cash -- a 22 percent premium to O2's closing share price on Friday -- sending the company's shares surging 24 percent to 203-1/4 pence by 10:17 a.m British time.

A successful 02 bid, the second-largest telecoms offer in Europe since the end of 2000, would allow Telefonica to break into the fiercely-competitive UK market and re-enter Germany, which it abandoned in 2002 after failing to build a greenfield mobile operation there.

"O2's integration in the Telefonica group will enhance our growth profile, it will allow us to gain economies of scale, it will open the group to two of the largest European markets with a sizeable critical mass and it will balance our exposure across business and regions," said Telefonica Chairman Cesar Alierta.

A source close to talks said Telefonica had approached O2 last week and was given access to the company's books over the weekend. "There was an approach and a series of negotiations and it got done very quickly," the source said.

O2, Europe's sixth-largest mobile phone company which owns assets in Britain, Ireland and Germany, is one of the few independent pure mobile phone operators and has long been tipped as a likely target to help trigger a new telecoms gold rush.

European telecoms behmoths have spent the last three years funnelling their sizeable cashflows into paying down debt. But even after starting to return cash to shareholders again with dividends and share buy-backs, analysts have said they have plenty of room on their balance sheets for major acquisitions.

Telefonica, the largest telecoms operator in the Spanish-speaking world, last surprised the market in March with a bigger-than-expected $3.57 billion (2 billion pound) bid for Czech carrier Cesky Telecom.

But when Europe's top former telecoms monopoly Deutsche Telekom teamed up with Dutch peer KPN for an aborted O2 bid in August, and France Telecom clinched 80 percent of Spain's third-ranked mobile group Amena, analysts said Telefonica risked being squeezed out of the European arena.

On Monday, investor hopes were high that Deutsche Telekom -- which had been hoping to fold its struggling T-Mobile cell phone business into O2's stronger-performing British arm -- would raise its hand and counter-bid.

"Do I think someone else will come to the table? Absolutely," said Deutsche Bank analyst Gareth Jenkins, adding that Deutsche Telekom could pay more than 200p a share with a cash-and-share bid.

"We made a bid a while ago but it was refused because of the price and that's it... We are not planning a counter-bid," a KPN spokesman said. Deutsche Telekom declined to comment.

Telefonica, whose shares were suspended in Madrid, said the deal would immediately boost earnings per share and that it had structured the financing of the deal to achieve an A- credit rating, or no more than one notch below.

The firm said it would generate an estimated 293 million euros of annual operating cost and capital expenditure synergies by 2008. The one-off cost of achieving the savings would be 39 million euros, Telefonica said.

A source familiar with the situation said Telefonica would fund the deal using loans provided by Citigroup, Goldman Sachs and Royal Bank of Scotland.

This is cache, read story here