Sitting upright at a reading table in his elegant Berlin flat, Friedrich Dieckmann stares at the last shreds of his dream dissolving in the air.

Barely two years ago, it seemed that Germany's finest baroque residence, which once dominated the heart of Berlin, with 1,200 rooms and a façade modelled on the Palazzo Madama in Rome, would soon rise from its ashes.

The diminutive 67-year-old writer, however, and other friends of Berlin's lost imperial palace had a rude awakening last month, when the odds in favour of one of Germany's most ambitious restoration programmes suddenly switched the other way.

For 300 years, the Berlin Schloss [castle] towered as an architectural beacon over the Prussian capital. But it ended in a black dust-cloud when Walter Ulbricht, leader of the young East German regime, had the Schloss razed in 1950. The monumental legacy of the Prussian monarchy - a political eyesore to the Communist rulers - was gone.

Then, last year, after a decade of dogged lobbying by Wilhelm von Boddien, a Hamburg entrepreneur, a decisive step was taken to resuscitate the court architect Hans Schlüter's Italianate masterpiece. In January 2002 an expert commission, which included Mr Dieckmann, had voted in favour of rebuilding the castle. Last year the German parliament endorsed the recommendation.

Yet, 15 years after the fall of the Berlin wall, the new German disease - empty public coffers, with politicians' fear of making decisions without universal consensus - looks likely to bury the endeavour for good.

"I am no longer optimistic that the castle will come," says Mr Dieckmann. "This is not a sign of strength for Germany. We are a paralysed republic."

Ostensibly, the debate that has sprung up is about the near-term fate of the Palast der Republik, the asbestos-ridden monstrosity erected on the castle's grounds in 1974 to house the Soviet satellite's joke parliament.

The Palast's steel skeleton, with its boarded-up windows and thick coat of graffiti, is due for demolition early next year, even though parliament has yet to find the €670m (£450m) needed for the castle's reconstruction.

Indeed, the Palast would be on its way out if a motley coalition of west German artists and commission-starved architects had not secured federal support and funding for a three-month arts festival in the gutted carcass of the building.

The "association for the interim use of the Palast" makes little secret of its unofficial goal: first to prevent the Palast's demolition, then to reverse parliament's "reactionary" decision.

"If a decision was wrong, even if it was a parliamentary one, why cannot you change it?" asks Amelie Deuflhard, a Stuttgart-born theatre director who is one of the association's founders.

The festival, which opened last month, will, she reveals, end with an architectural congress where blueprints for a modern alternative to the baroque reconstruction will be presented.

The prospect is causing alarm in the pro-castle camp. The main problem with the Palast is less its ugliness - the communist utopia on Alexanderplatz is bigger and more depressing - than its location, a void many think cannot be filled by a trophy modern building.

The shoebox spoils the perspective of the Unter den Linden Boulevard, whose eastern edge is the only sizeable architectural ensemble in Berlin to have been restored to its pre-war state, mostly under the communist regime. The castle, advocates say, was the cement linking the Old Armoury to the National Library and Humboldt University, which bore an organic relationship to the Schloss when built.

"The thing is just ugly," sums up Günter Nooke, a Christian Democratic member of parliament and nemesis of the anti-castle camp. "What message does this send about Germany if 15 years after reunification the very heart of the country's capital is still soiled by this shameful stain?"

"We need to rebuild the castle for the same reason that Mostar needed to rebuild its bridge, or Venice its Campanile," says Mr Boddien, the original lobbyist. "It is about the identity of the place. Why do you think there are so few Paris postcards showing La Défense or the Tour Montparnasse?"

Ms Deuflhard's association has gained a powerful ally in the PDS, successor to the German Democratic Republic's ruling party and member of the ruling coalition in the Berlin state government, and particularly in Thomas Flierl, councillor for culture.

Mr Flierl, a genial East Berliner, says Berlin deserves a "Centre Pompidou", not a Disneyland Prussian pile. "As a councillor, I am bound by the parliament's vote. But I cannot see the political will to implement it. The pro-castle vote was an ideological decision. We have moved on. There is an opportunity to . .. build a post-GDR, not a pre-GDR, monument."

The castle project was never popular in East Berlin. Ostalgie - nostalgia for the late GDR - is bolstering the anti-castle camp. So is the sense of victimisation in the unemployment-ridden region. It is no accident that the opening of the Palast festival mixed post-apocalyptic aesthetics with Stalinist kitsch: the venue was renamed Volkspalast (people's palace) and visitors were offered free rides to the door in "Volkslimos" (people's limousines).

Help for the anti-castle faction has also come from an unexpected quarter: eager to polish their proletarian credentials amid mounting business-bashing agitation, the BDI industry federation and McKinsey, the management consultancy, have held events in the Palast's ruins.

The gloom is palpable among castle friends. Gerhard Schröder's government, cash-starved and unpopular, is, they suspect, in no hurry to pour half a billion euros into what several of its members see as apolitically incorrect enterprise, after three years of economic stagnation.

As the slow gears of the German compromise-seeking machine creak back into motion, empty coffers, political lethargy and the lack of a convincing alternative to the castle suggest Berlin's scarred historical core is here to stay, like a renaissance Madonna with her eyes gouged out.