Talks are to continue on Thursday but the threat of strike action now looms as unions say the chances of reaching an agreement are small.
Volkswagen is the latest German firm to take on the unions as it looks to cut costs as competition intensifies.
The company has warned that 30,000 jobs could be lost at its six German plants unless staff accept a two-year pay freeze.
The IG Metall trade union initially demanded a 4% annual increase in wages.
It has now tabled plans to lift salaries by 2.2% and by 2.7% from March, 2005.
Volkswagen said that the demands were still excessive.
"IG Metall is obviously not prepared to concede the necessary drop in costs in exchange for job guarantees," said Volkswagen's chief negotiator Josef-Fidelis Senn.
The company is looking to trim costs by €500m (£345m) as it faces growing competition from rivals operating out of low-cost eastern European markets.
As well as a two-year pay freeze, VW wants workers to accept longer working hours without extra pay and a reform of overtime payments.