(Reuters) — The European Union should take action against Chinese telecom equipment makers because their increasing dominance of mobile networks makes them a threat to security as well as to homegrown companies, an internal E.U. report has recommended.

Echoing similar security concerns to those in the United States and other Western countries, the report argued that action is needed over equipment sold in the European Union by Huawei and smaller rival ZTE.

Their combined share of the E.U. telecoms equipment market has risen to 25% from 2.5% in 2006 at the expense of EU suppliers such as Nokia Siemens Networks, Alcatel-Lucent and Ericsson.

In 4G/LTE infrastructure for the latest data-hungry tablets and smartphones, the Chinese firms have won 57% of all contracts awarded so far in the 27-member European Union.

"The growing presence of the Chinese in the telecoms market is increasingly viewed by all E.U. participants in this sector, including industry experts, as a major security risk," said the report, prepared in May by the European Commission, the E.U. executive.

The report, seen by Reuters on Wednesday, specifically mentioned the potential for spyware to be inserted into the telecom equipment that even operators would be unable to locate.

The arguments over competition and security were closely entwined, with the report saying that still higher reliance on Chinese firms if E.U. firms went out of business would increase the risk.

The report was prepared as the commission gathered evidence for a possible anti-subsidy case against the firms — something it has not yet decided to begin. E.U. sources said the report was still under discussion by the commission and member countries.

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One option could be for the commission to start an investigation into possible trade subsidies, which it suspects the companies receive from Beijing.

Although such a "trade defense investigation would be a very unusual step, we believe that from a technical perspective it is justified under these special circumstances," the report said.

A commission spokesman declined to comment on the report.

Other potential action could include a challenge against China at the World Trade Organization, but the length of such proceedings could mean remedies came too late to help European companies, the report said.

A Huawei spokeswoman, Tina Tsai, said the report appeared to be based on a misperception.

"It is because of this economic crisis that we are seeing growing protectionism," she said. "If you really focus on one country and one company, ignoring the real threat of cyber-security, then definitely I think it is really unfair."

ZTE said its European spokesman was currently in China and not immediately available for comment.

Dealing with the Chinese companies presents the European Union with a dilemma on both the business and diplomatic fronts.

Although E.U. suppliers might benefit from protection against Chinese competition, they also do business in China and worry about a potential backlash there if they bring a complaint.

Moreover, Huawei has made large investments in Britain and Finland. Huawei said on Monday it planned to double its workforce in Europe, seeking growth outside the United States.

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The U.S. House of Representatives' Intelligence Committee has urged U.S. firms to stop doing business with Huawei and ZTE, saying they could pose a security threat because of ties to the Communist party. Australia has blocked Huawei from tendering a bid to supply its national broadband network and Britain's parliament has begun an inquiry into Huawei.

China has dismissed any security concerns, with one Chinese minister accusing the United States of a "Cold War mentality".

Prices of equipment from Huawei and ZTE were on average 18% below those of E.U. producers, the E.U. report said.

"The situation has already led to serious job losses for one of the major E.U. producers," it said, referring to Nokia Siemens, "and the other two are expected to follow suit shortly." It said that two, or even all, E.U. producers could disappear.

"This would significantly increase the degree of E.U. dependency on Chinese-produced equipment with a corresponding increase in security risk," the report said.

Despite the danger of diplomatic fallout, a case over telecoms might put the European Union in a stronger position in the discussion over wider Chinese export subsidies.

Security concerns are normally the domain of individual E.U. member states, but the commission handles trade issues for the whole bloc. The commission is also working on binding cyber-security legislation.