The deal, which values innogy's equity at €22bn ($27.1bn), will also see a series of asset swaps take place between the two companies.
Share in Innogy, RWE, and E.ON all surged this morning as the markets responded positively to the news.
The logo of German energy company Innogy at its headquarters in Essen.
"Overall, we view the planned transaction between RWE AG and E.ON SE as positive, from a strategic as well as a financial point of view", municipal shareholders in RWE, which together hold about 23 percent in the group, said.
This move would transform both companies, giving RWE a combined share in wind power second only to Iberdrola in Europe, and giving E.ON a share of the retail market that could raise antitrust implications in Germany, where the two companies are already dominant players, and in the United Kingdom, where they are two of the six biggest retailers. One source said Australia's Macquarie MQG.AX had also been in the race.
However, Innogy, which reported its annual results on Monday, said that it had so far not reflected on the proposal and would comment at a later stage.More news: Trump may exempt more countries from tariffs: Treasury's Mnuchin
Boards of both companies still need to approve the transaction.
Innogy and E.ON have large overlapping retail businesses in Germany and Britain.
Shares in RWE, which owns 76.8 percent of Innogy, closed 9.2 percent higher while E.ON's ended the day up 5.4 percent.
"It was a competitive process", one of the sources said, adding that RWE had chose to strike the deal with E.ON after considering proposals from peers.
If approved, the deal would spell the end for Innogy as a standalone company. Chief executive Peter Terium resigned late past year in the wake of a profit warning leaving Uwe Tigges as interim CEO.
Morgan Stanley analysts said the proposed deal would allow E.ON to expand its networks and retail businesses, with potential for "material" cost cuts, while RWE would gain a long-term renewables strategy and a stable dividend from E.ON. Today it reported 2017 results, saying its adjusted net profit grew by 9% to more than Euro 1.22 billion.