The latest shock development in Australia’s National Broadband Network (NBN) saga sees the federal government calling Telstra’s bluff and excluding the tantrum-throwing telco from the tender process.

After much smack-talk and political demands on Telstra's part, today it was excluded from the multibillion dollar project on a technicality - for not providing the government with a plan on how it would involve small and medium businesses in the building of the network.

The market reacted strongly to the news with Telstra's shares down 9.44% in late trading on the ASX.

Telstra Chairman Donald McGauchie immediately attacked the decision, saying the government "could hardly have dreamed up a more trivial reason to exclude Telstra from the NBN," and going on to label the grounds for Telstra's exclusion "legally questionable".

When the NBN request-for-proposal closed on November 26, Telstra failed to place a full bid. While rival Optus placed a 1000-page document following the federal government’s RFP guidelines, Telstra delivered a “counterproposal” in the form of a 13-page letter to Communications Minister Senator Stephen Conroy.

Telstra’s letter was short on NBN technical detail, but big on demands, including a guarantee that it would not undergo a Telecom New Zealand-style operational separation during the lifetime of the network. The company also proposed only offering full speed broadband to around 65% of the population (to the RFP’s 97% requirement) and demanded a $A5 billion concessionary loan to top up the $A4.7 billion of taxpayer funds the Rudd Labor government has already allocated to the fibre optic project.

Senator Conroy immediately took legal advice on whether Telstra’s letter constituted a valid proposal under the RFP guidelines.

Telstra seemed confident as the Communications Minister weighed his options, with Chairman Donald McGauchie launching a series of colourful attacks on the company’s NBN rivals (the government received six proposals in all; from November 26 an expert panel assembled by Mr Conroy had eight weeks to determine a preferred bidder).

But now Senator Conroy has called Mr McGauchie’s bluff, announcing this morning that Telstra has been excluded from the RFP process.

Mr McGauchie was quick to return fire, saying “The decision to exclude us from the RFP is the Commonwealth’s decision to make. But Telstra is the only company to have submitted a proposal with a real financial commitment – of $A5 billion.

“And Telstra is the only company with the existing network, technical systems and proven track record of building world class networks.”

But to get a shot at building the NBN, it looks like MrGauchie and Telstra will have to start playing nice, and come back to Senator Conroy with a more detailed proposal.

Telstra CEO Sol Trujillo says his company is not out of the running, as the RFP process leads to negotiations with a preferred bidder, not a winning bidder.

"It is too early to rule anything in or out, and we remain hopeful that sense will prevail outside the RFP process at a later date," says Mr Trujillo.

"This is the largest, most complex NBN build anywhere in the world. Australia now risks being the only country ever to build an NBN without the existing fixed network owner in the most difficult financial climate in decades," the company says in a statement.