Hitachi Ltd is in talks with Toshiba and Sony about joining the merger of their liquid-crystal display (LCD) units, a move that would create the world's largest maker of small panels, two sources with knowledge of the matter said on Thursday.

Hitachi has been in separate talks with Hon Hai Precision Industry about a joint venture in LCD panels but those talks have hit difficulties, one of the sources said, making the Japanese conglomerate more likely to join the domestic partnership.

If the three-way alliance goes ahead, the mainly government-funded Innovation Network Corp of Japan will consider investing about 200 billion yen ($2.5 billion) in the merged unit, one source said.

The Nikkei newspaper earlier reported the government fund would likely gain a 70 percent stake for that amount and the three companies would then split the remaining interest. A listing sometime in the future is possible, it said.

Hitachi declined to comment.

Toshiba and Sony are negotiating to merge subsidiaries making the panels, which are used in tablets and smartphones, sources said earlier this month, as they battle harsh competition from Asian rivals like Samsung.

Hitachi wants to distance itself from the volatile panel business, which requires regular large-scale investment to keep up with cut-throat price competition, in order to focus on its social infrastructure business.

Its talks with Taiwan's Hon Hai, the parent of Chimei Innolux Corp had involved plans for Hitachi's display making subsidiary, Hitachi Displays, to issue shares to Hon Hai and the companies to jointly build a new factory outside Tokyo.

Hitachi's shares were 0.4 percent lower at 470 yen compared with a flat broader market.

Japan's Sharp Corp, currently the world's largest maker of small LCD panels, said this month it would switch most production at one of its TV panel plants to small panels.

(Writing by Isabel Reynolds; Editing by Edwina Gibbs)