French food group Danone said it would sue wholesale dairy exporter Fonterra and stop buying products from the New Zealand firm following a contamination scare that sparked the recall of infant milk formula across Asia.

The world's largest yoghurt maker did not say how much money it was seeking, but it has previously said it wanted full compensation for what it says were 350 million euros ($476 million) in lost sales following the recall of the company's Dumex and Karicare infant formula products.

Danone is one of Fonterra's biggest milk powder customers, according to analysts who cover the sector. Fonterra, which said it would contest the suit "vigorously", declined to give details on its sales to the French firm.

In August, Fonterra said it had found a potentially fatal ingredient in a range of products sold by multinational companies. After recalls were issued across nine countries including China, the scare turned out to be a false alarm because the ingredient was found to contain a less harmful bacteria.

In a statement, Danone said it was starting proceedings in the New Zealand High Court against the world's largest dairy processor, which supplies a range of dairy ingredients to the French firm. Danone would also start arbitration proceedings in Singapore to obtain compensation.

The company said it was also terminating its supply contract with Fonterra and would make any further collaboration contingent on a commitment by Fonterra to full transparency and compliance with Danone's food safety procedures.

"This affair illustrates serious failings on Fonterra's part in applying the quality standards required in the food industry," Danone said.

Danone told Reuters it would source products from other global suppliers, without elaborating.

Fonterra, a farmer-owned co-operative, has denied any legal liability to Danone regarding the recall.

"Fonterra has been in ongoing commercial discussions with Danone and is disappointed that they have resulted in legal action," the company said in a statement.

Units in its sharetrading fell around 2 percent on the announcement.

SETTLED WITH SEVERAL CUSTOMERS

The two sides started negotiations in October, after Danone recalled its Dumex formula products in China, where demand for foreign branded infant formula is high due to a series of domestic food quality issues.

Baby food accounts for 20 percent of Danone's revenue, second only to its dairy business, and Asia, notably China, is a key growth market at a time of sluggish demand in Europe.

Eight companies issued product recalls in August. Danone is the first to take legal action against Fonterra. In December, Fonterra said it had reached agreements to compensate six firms and that it was "very, very close" to an agreement with an affected nutritional company.

New Zealand's largest company controls roughly one-third of global dairy exports and is a major wholesale supplier of milk powder used in milk formula and other food products marketed by Danone, Nestle and other multinationals.

A big court settlement in Danone's favour would hurt Fonterra's bottom line given that it has already slashed its earnings and dividend forecast on the back of rising production costs at a time when it is struggling to keep up with soaring demand for milk powder.

"A large fine of the magnitude that Danone ... has stated would have a material impact. You'd have to either remove your dividend or address your capital structure," said Rickey Ward, head of equities at Tyndall Investment Management in Auckland.

The food safety scare as well as drought in New Zealand which curbed supply in early 2013 has highlighted the risk of over-reliance on one supplier. Some dairy brands in China, for example, have started to look to diversify.

Fonterra's much smaller competitors in New Zealand would not comment on whether they had seen more business from Danone as a result of the dispute.

Ward said that given strong global demand for dairy products, particularly from China, Fonterra was unlikely to have problems finding new buyers to replace cancelled orders.

"It's not nice to lose a big customer ... (But) there's large global demand and short supply so Fonterra may be able to fill that void if there is a big void," he said.

(Editing by Dean Yates)