Chancellor Angela Merkel has reportedly warned David Cameron she would rather see the UK leave the EU than compromise over the principle of free movement.
Der Spiegel news magazine quotes German government sources as saying she feared the UK was near a "point of no return".
Chancellor George Osborne dismissed the story as speculation about how Germany may react to a future UK policy shift.
But he insisted ministers would act in the national interest in addressing public concerns about immigration.
He told BBC Breakfast that concerns about abuses of the benefit system were causing "great unhappiness" but the UK would approach future negotiations in a "calm and rational" way.
Mr Cameron wants to renegotiate the terms of the UK's continued membership before holding an in-out referendum.
The prime minister has insisted that freedom of movement of workers would be "at the very heart of my renegotiation strategy for Europe".
But Mrs Merkel is said by the magazine to have made clear she will withdraw her support for the UK's continued EU membership if he continues to push for migration reform which requires fundamental changes to the principles of the organisation.
The German chancellor's warning to Mr Cameron is reported to have come in a meeting on the fringes of the latest EU summit in Brussels last week.
Der Spiegel, quoting sources within the German chancellor's office and German foreign ministry, said this was the first time Mrs Merkel had acknowledged that the UK's exit from the EU was possible.
"Should Cameron persist (in this plan), Chancellor Angela Merkel would abandon her efforts to keep Britain in the EU," it quoted the sources as saying.
"With that a point of no return would be reached. That would be it then."
According to the Sunday Times, Germany has already rejected a proposal to impose quotas on low-skilled EU migrants by limiting the national insurance numbers issued to them.
Der Spiegel reported that Mr Cameron was now looking at a plan to stretch the EU rules "to their limits" in order to ban migrants who do not have a job, and to deport those who are unable to support themselves after three months.
'No iron lady'
Conservative MP David Davis said Mrs Merkel was an "important" figure in Europe but "she is not an iron lady", suggesting she was also likely to come under pressure from within Germany to restrict immigration within Europe from countries with lower average incomes.
He told BBC's Radio 4's Today programme that any British official calling for a "German compliant" re-negotiating approach should be removed from their job.
On Sunday, Conservative MP and former justice secretary Kenneth Clarke defended EU migration.
"If you're going to have a sensible single market, if we want to compete with the Americans and the Chinese and so on, we need the free movement of labour," he told BBC's Sunday Politics.
A Downing Street spokesman said Mr Cameron would make a speech on immigration before Christmas, and stressed "you can be sure he will always put Britain first."