The EU's anti-fraud office on Monday urged Gibraltar and Spain to launch legal action after it found signs that organised crime was behind a rise in cigarette smuggling in southern Spain.
The European Anti-Fraud Office (OLAF) made the recommendation after completing a probe it launched in August 2013 at the request of Madrid into a sharp rise in cigarette smuggling across the border between Gibraltar and Spain between 2009 and 2013.
"The OLAF investigation has raised a number of concerns regarding the link between a significant increase in the size of the Gibraltar market for cigarettes over the past four years and the subsequent increase of cigarette smuggling across the frontier," a spokesman for the anti-fraud office said.
"The concerns include indications of the involvement of organised crime," it added.
"The OLAF final case report, and recommendations to initiate judicial proceedings related to the findings of the report, have been sent to the Spanish General State Prosecutor and to the Gibraltar Attorney General."
Widespread cigarette smuggling between the tiny, low-tax British territory of Gibraltar to Spain is a major irritant in their frayed diplomatic relations.
Smugglers buy the cigarettes in large volumes in Gibraltar at a price much lower than is charged in Spain, where the government in 2012 increased the sales tax to help plug a gaping public deficit.
Spain in August introduced stringent border checks at its border with Gibraltar, leading to lengthy queues for motorists, in what it said was a move aimed at clamping down on cigarette smuggling.
But Gibraltar argues the stepped-up border controls are in retaliation for the installation of an artificial reef in its waters that has prevented Spanish boats from fishing there.
Gibraltar Chief Minister Fabian Picardo welcomed the anti-fraud office report and said the territory wanted to work together with Spain to investigate the cigarette smuggling.
"We wish any necessary investigations in this and in all areas to be carried out jointly between the competent Spanish and Gibraltar authorities in a genuine spirit of cooperation," he said.
The government of Gibraltar said cigarette smuggling was already being brought under control thanks to the "draconian" measures it introduced in January.
These include the introduction of searches of vehicles crossing into Spain and giving customs and police officers greater powers to fight smuggling.
The Spanish government meanwhile said the anti-fraud office's report "justified" its "work in the fight against fraud and the underground economy".
Spain ceded Gibraltar to Britain in 1713 but has long argued that it should be returned to Spanish sovereignty. London says it will not do so against the wishes of Gibraltarians, who are staunchly pro-British.