Negotiations on Hong Kong's future began in September 1982 when Thatcher met Chinese leaders in Beijing. She told Premier Zhao Ziyang that China's proposals for Hong Kong to become a largely self-governing special administrative zone of China - essentially the 'one country, two systems' framework in effect today - would be "disastrous" for investor confidence and lead to its collapse as a financial centre.

She continued that "there would certainly be a wholesale flight of capital from Hong Kong" and that "this money, having left Hong Kong, would not return". Thatcher concluded: "We believe that that plan would lead to the collapse of Hong Kong as a financial centre."

To maintain investor confidence, Britain wanted to continue administering Hong Kong after 1997 under Chinese sovereignty. Thatcher said: "Confidence in Hong Kong, and thus its continued prosperity, depend on British administration."

Unsurprisingly, China rejected this. Zhao is recorded in the British minutes of the meeting as responding: "China would not let others administer Hong Kong on its behalf nor place Hong Kong under the trusteeship of others".

Thatcher initially refused to alter her position and negotiations stalled. On one paper prepared for Thatcher in February 1983 by the Foreign Office which suggested alternative negotiating stances a scribbled note signed 'MT' - almost certainly standing for Margaret Thatcher - stated: "This paper is pathetic - it is a recipe for a sell-out."

Thatcher even requested from her civil servants an assessment of the military capability to defend Hong Kong should China seek to over-run the colony - a surprising request given China's much larger armed forces. The assessment concluded: "The [Hong Kong] garrison could deal with a small-scale incursion but would be limited to establishing the facts of any large-scale attack."

The British prime minister believed China could be persuaded to let British administration continue in return for gaining sovereignty over all of Hong Kong. Under the 19th century treaties between Britain and China, Thatcher argued Hong Kong Island and Kowloon could remain British. The New Territories were ceded to Britain in a lease which expired in 1997.

But China did not recognise these treaties and demanded the return of all of Hong Kong in 1997. Substantive negotiations resumed in the summer of 1983 but tensions remained high.

Zhou Nan, one of China's negotiators, said Britain's attempt to continue administering Hong Kong after 1997 reflected "a colonialist and imperialist attitude [which] was outmoded, lacking in reality and would get nowhere with the Chinese government or people." Zhou added: "If British administration was so good why had so many people in former British colonies fought for independence?"

Cradock was highly critical of China's leaders in a dispatch to London. He wrote: "The Chinese leaders are incorrigible and ineducable, otherwise they would not be where they are." He added: "They are elderly men with rigid views, blinkered by dogma and national pride and deeply ignorant of how a place like Hong Kong works."

Cradock, who would later clash with Chris Patten as the last British governor attempted to spread democracy in the colony, realised that Britain was not going to convince China of continued British administration - and believed a Plan B was needed. In August 1983 he cabled London: "We should ponder now whether there is anything short of our present demand for the continuity of British administration intact which would be sufficient to avoid a collapse of confidence in Hong Kong." He added: "It is quite plain that we shall not achieve our ideal solution."

Negotiations continued but Britain became concerned that China may abandon the talks. In November Geoffrey Howe, Britain's foreign secretary, briefed senior cabinet colleagues including Thatcher that the outlook for the talks was "bleak". If Britain continued to push for the right to administer Hong Kong "there was a risk that the Chinese might break off the negotiations [which] could well precipitate a breakdown of confidence in Hong Kong", according to the minutes of the meeting.

By December Thatcher had softened her position and Britain's negotiations with China that month took place in an "improved atmosphere". Following this round of talks between China and Britain, Howe briefed senior cabinet colleagues that future negotiations would have to be "on the basis of the Chinese proposals" with the aim of making them "more acceptable and workable", the minutes reveal.

But given Britain's weak negotiating stance Howe raised the question of whether they should withdraw from the negotiations: "While British comments could be expected to have some impact on the Chinese proposals, there was no certainty that the outcome would be subject to agreement with the UK. It was therefore necessary to consider whether the present strategy should be continued or the talks broken off."

During subsequent discussion at this briefing, numerous future scenarios were discussed. The minutes record "the point was made that there was no prospect of reaching an agreement with the Chinese which could be commended to [the British] Parliament". The possibility was also raised that negotiations with China may produce no agreement at all. If that happened the minutes recorded: "It was by no means clear that [China] would be prepared simply to wait until the [New Territories] lease expired."

They feared that if Deng Xiaoping "could not reach an agreement with the British government which was satisfactory to him, he might decide upon an early takeover of Hong Kong".

But for Britain to "precipitate a breakdown of the talks would be even more damaging", the minutes state. It was essential for Britain to show it had done everything it could to reach an agreement, they say.

Negotiations with China continued and in December 1984 Thatcher signed the Joint Declaration with Zhao that returned Hong Kong to China in 1997 under a broadly autonomous local government. More declassified files to be released at the end of this year should shed light on the final discussions ahead of the Joint Declaration being signed.

Zhao was placed under house arrest in 1989 after taking a conciliatory approach to the Tiananmen Square student protesters before the military crushed the demonstrations. He died in 2005. Thatcher was toppled as prime minister in 1990 by members of Parliament and died this April.

Timeline of handover of Hong Kong to China

Governor Murray MacLehose meets Deng Xiaoping and raises the issue of Hong Kong for the first time

Premier Hua Guofeng visits Britain and meets new Prime Minister Margaret Thatcher. Both express a wish to maintain Hong Kong's stability and prosperity

Thatcher meets Deng in Beijing and formal negotiations on the future of Hong Kong begin

Thatcher and Deng sign the Sino-British Joint Declaration, paving the way for the creation of the Hong Kong Special Administrative Region

British rule in Hong Kong ends and China resumes sovereignty