Egypt depends on the Nile for virtually all of its water and is mounting a major diplomatic and economic campaign to scupper the plan. "Even direct military action by Egypt cannot be ruled out," observed the U.S. global security consultancy Stratfor.
Both countries have undergone major political upheavals recently, which have added to the tension in a long-running battle for control of the world's longest river which rises in the Ethiopian highlands.
Egypt's Muslim Brotherhood now controls the presidency and Parliament following the February 2001 downfall of longtime dictator Hosni Mubarak and is locked in a struggle for supremacy with the military.
Longtime Ethiopian ruler, Prime Minister Meles Zenawi, as harsh a dictator as Mubarak and whose ethnic Tigray group has long dominated the military, died Aug. 20, leaving a leadership vacuum and internal rivalries.
Meles, who came to power in 1991, had long opposed the domination of the Nile's water flow by Egypt, and to a lesser extent Sudan, under colonial agreements that left the upstream African states -- Ethiopia, Kenya, Uganda, Burundi, the Democratic republic of Congo, Rwanda and Tanzania -- with almost no control of the river's resources.
He found Cairo's hard-line position on the Nile particularly galling because 85 percent of the river's water flows from the Ethiopian highlands.
There were years or fruitless negotiations between Cairo and the upstream states in the Nile Basin initiative, a forum set up in 1999 by all the Nile states.
But in 2010, Egypt found its domination of the river heavily challenged.
Ethiopia and four African states -- later joined by two more -- threw out a 1959 agreement imposed by British colonial rulers that gave Cairo control of 90 percent of the Nile's water and veto power over dam construction upstream that would limit its water supplies.
They contend they need more water because of burgeoning populations, industrialization and agricultural projects.
The fall of Mubarak, who had fiercely opposed surrendering any of Egypt's control of the Nile, left Cairo adrift.
Meles, who had already built seven small dams on the Nile, took advantage of Egypt's disarray to announce his plan for the $5 billion Grand Ethiopian Renaissance Dam on the Blue Nile and start work on it.
"Cairo fears that once the dam is completed in 2017, it will take two to three years, depending on rainfall, to fill up the 67 billion cubic meter reservoir, which could reduce the amount of water that flows into Egypt by 25 percent," Stratfor observed.
"After the reservoir fills up, there is no guarantee that Egypt will maintain its present share of the water, and Ethiopia is already planning multiple agricultural projects on Nile tributary rivers flowing from the Ethiopian highlands.
"Speeding up the diversion of water would put added pressure on Cairo," Stratfor noted.
So far Cairo has focused primarily on diplomatic efforts with Ethiopia and its African allies, concentrating on these countries' parliaments whose agreement on a new water-sharing arrangement will be necessary if it is to be legally binding to supersede the 1959 agreement.
According to documents released by WiliLeaks in September, the Egyptian and Sudanese governments had planned to attack the Grand Renaissance Dam.
WiliLeaks claimed the documents originated with Stratfor. The Texas-based consultancy's computer system was penetrated before the leaks and that may have been how the alleged documents were uncovered.
One 2010 email quoted a "high-level Egyptian source" as saying "we are discussing military cooperation with Sudan" against Ethiopia, establishing a base there from which to fly Egyptian Special Forces to destroy the Ethiopian project.
Egypt denied it had such a plan. But Stratfor noted that if diplomacy fails, "Egypt's next most likely approach is to support proxy militant groups against Ethiopia" as it did in the 1970s and 1980s.
Stratfor said direct military action "was the least likely approach and one Cairo would undertake only if the dam was completed and significantly interrupted the water flow.
"Such a course will also largely depend on Egypt's new leadership ... but whatever its political inclination, a large-scale reduction in water from the Nile would be intolerable to any Egyptian government."