CTV News has learned a weekend letter on the Atlantic Accord dispute has left Prime Minister Stephen Harper facing a major cabinet split.

Sources say that Foreign Affairs Minister Peter MacKay feels blindsided by the letter to the editor published Saturday that inflamed matters.

Insiders say that Sandra Buckler, the prime minister's communications director, instructed MacKay to sign the letter, which rejected any side deals with Nova Scotia.

MacKay, a Nova Scotia MP and the senior minister for Atlantic Canada, refused, say sources. Finance Minister Jim Flaherty signed the letter.

Nova Scotia pulled out of talks with the federal government in response. Conservative Premier Rodney MacDonald called on Atlantic MPs to vote against the federal budget.

Liberal senators, who hold a majority, say they might even take up MacDonald's call to defeat the budget.

"If Mr. Harper wants this budget, Mr. Harper is going to have to change this budget," said Liberal Sen. Terry Mercer of Nova Scotia.

Having the Senate vote down the budget would be a vote of non-confidence in the government and an election could result.

"It would be totally irresponsible and it would be unprecedented for the unelected Senate to defeat a budget bill," said Conservative Sen. Marjory LeBreton, the party's house leader.

Robert Fife, CTV's Ottawa bureau chief, reports that MacKay is trying to broker a deal with MacDonald and convince Harper that if he doesn't compromise, he could pay a high political price.

Harper's challenge

Earlier Monday, Harper told Nova Scotia and Newfoundland and Labrador to take his government to court over their allegations that he is tampering with the Atlantic accords.

"It's an allegation without substance. I welcome continuing to sit down with the Nova Scotian government to resolve this but I don't think we can let that allegation stay out there forever," Harper told reporters.

"At some point we will consult tribunals ourselves if that's necessary to get a ruling on our respect for the contracts."

Nova Scotia officials say federal changes to the province's accord would mean the loss of about $1 billion in revenue over the next decade.

But Harper denies those allegations and says such serious charges cannot be left uncorrected.

"If you're really serious in the allegation we've broken a contract, then I think that you have to follow that allegation up with action," Harper said.

"We're prepared, if we cannot pursue an accord with Nova Scotia and the others, ... to consult the courts ourselves."

Harper said Nova Scotia is receiving $95 million more in equalization transfers under his government's new budget than it is entitled to under the accord.

The federal government is going to stick to the principals set out in the budget, he said, adding the fiscal framework "respects the provinces."

"We cannot give new accords to these provinces. We have to comply with the ones that have been signed," Harper said.

The prime minister was to meet Monday night with Nova Scotia MP Gerald Keddy to discuss the dispute.

Keddy told The Canadian Press he was shocked by the Flaherty letter and said he is now between a "rock and a hard place."

MP Bill Casey got kicked out of the Conservative caucus last week after he voted against the budget.

Keddy and MacKay are the two remaining Conservative MPs from the province, which has 11 federal seats.

Asked why the Conservatives might be digging in their heels on this, Fife said it's the prime minister trying to protect the reputation of Flaherty.

"(Flaherty) had to backtrack on income trust, he had to withdraw a major budgetary measure, and the last thing they want to do is have him embarrassed by having him climb down on this equalization issue," he said.

But the price might be having the Conservatives wiped off the political map in Nova Scotia and Newfoundland and Labrador in the next federal election, Fife said.

Question period

In Parliament's question period on Monday, Liberal Leader Stephane Dion said, "There's no need to go to court to know that the prime minister broke his electoral promise to Saskatchewan, Nova Scotia and Newfoundland and Labrador."

He quoted Harper as saying in the 2006 election that there would be no caps or clawbacks of equalization payments.

"The government committed to bring in a new equalization formula that would be based on clear principles and treat everyone equally," Harper said.

Existing side deals like the Atlantic Accord were left in place, he said.

Dion noted some clauses from Bill C-52, the budget implementation bill, do claw back and impose caps -- something the accord was supposed to protect against.

The new equalization formula "does have a cap, but that cap does not apply to Newfoundland and Nova Scotia, because Newfoundland and Nova Scotia have the right to exactly the deal they signed in 2005," Harper said.

"What we will not do is provide an enhanced side deal for any province."

Speaking to reporters after question period, Flaherty said Nova Scotia can ignore the new formula and keep the accord and the old formula.

When Nova Scotia signed on to the new formula, it didn't think it was ready to do so permanently, he said.

"So we said to them, 'fine. Do it for a year. Review the options between the accord and the modified O'Brien formula'," Flaherty said.

The two Atlantic provinces say the accord entitles them to the benefit of any changes to the system.

MacDonald explained it this way in a letter to the editor:

"Suppose you are an employee in a company and you achieve a bonus from your boss. You take that bonus and put all of it against your mortgage. Two years later the company is doing better so the boss gives everyone a raise. But he gives you a choice between your old salary with the bonus you got two years ago or the raise. But the catch is that if you take the raise you have to pay back the bonus you got. Is that fair?"

MacDonald speaks

In Toronto on Monday, MacDonald continued to make his displeasure known.

"On March 19, when we heard the budget, it was very clear to us the accords weren't being honoured," he told CTV Newsnet's Mike Duffy Live.

"We entered negotiations (with the Harper government) in good faith."

But Saturday's letter to the editor from Flaherty "indicating to Nova Scotians this was nothing more than an urban myth" was the last straw, he said.

The Conservative premier broke off negotiations has urged all MPs in his province to vote against the federal budget.

The 2005 Atlantic Accord, a deal signed by the then-Liberal government between the governments of Nova Scotia and Newfoundland and Labrador, protects the two provinces from having their offshore oil and gas royalties clawed back under the federal equalization plan.

However, to accept an enriched equalization deal, they have to abandon the accord. While Nova Scotia receives $95 million more this year, it maintains that the clawbacks will begin in subsequent budget years.

MacDonald said this could ultimately cost his province up to $1 billion. "A province of Nova Scotia's size cannot afford to lose a billion dollars," he said.

Fighting this in court, as Harper suggests, would cost millions of dollars and take years to resolve, he said.

"Those that were involved in the agreement know what they signed ... the only ones who don't get it are the federal government."

Saskatchewan's provincial NDP government, meanwhile, has also been locked in a dispute over resource revenue and equalization with Ottawa.

Saskatchewan is affected because while provinces can remove oil and gas revenue from the equalization formula, a cap could then be placed on the amount of money paid out.

Premier Lorne Calvert has said the move has cost his province hundreds of millions of dollars.

Calvert and Danny Williams, the N.L. premier, have tried to maintain a united front against the feds.

The final vote on the budget is expected to be one of the last major acts of this session of Parliament, although MPs could sit as late as June 22.

With a report from CTV's Robert Fife and files from The Canadian Press