The U.S. Department of Interior is threatening to scuttle plans for major renovations to Capitol Hill's Eastern Market that have taken several years to develop and cost the city more than $500,000.

In a letter to renovation opponents last week, an Interior official said agreements between the District and federal governments made when the city accepted several federal preservation grants for the site prohibit the city from moving forward with $3.3 million in upgrades now in the final design stage.

The ruling from Gary L. Hume, acting director of the Interior's preservation assistance division, shocked project organizers, who said it could kill plans to add a second floor in the barn-like structure on D Street SE, to move its art gallery upstairs to make room for a dry goods store and to install elevators and public restrooms.

Hume said the second-floor addition and changes to several doors and windows would alter the building's historic integrity, which grant agreements strictly prohibit.

"Taken as a whole, the changes to the Eastern Market . . . will significantly diminish the historic character of this important resource," he wrote.

The plan was developed by the Eastern Market Preservation and Development Corp., a group of 10 mayoral appointees and 24 Capitol Hill community leaders established in 1987 to devise an improvement plan.

In recent months, the final proposal, which must still win city approval, has sharply divided the neighborhood, as opponents, including preservationists and merchants resistant to rent increases, gathered force.

This week, city officials blasted the Interior Department's interference, disputing the existence of restraining agreements and vowing to move forward with the plan.

"There isn't really a covenant as such," said Stephen Raiche, the city's deputy state historic preservation officer. "A covenant only exists when there is a deed, and there is no deed in this {case}, because it is public property."

"There's a time and a place for second thoughts," said Chris Britton, of the D.C. Office of Business and Economic Development. "This project is extremely far along. The plans and specifications are 95 percent complete . . . . Our job is to move ahead."

Members of the Eastern Market development corporation called the news a blow to their rehabilitation plans.

"It isn't going to go. There are too many problems that have been raised . . . . In my view that is it. They are the historical preservation experts," Karen Walker said.

"If this is the verdict, I accept it. I'm only sorry that this particular opinion was not sought by the corporation authorities before so much time and money was spent."

A request for the Interior Department ruling came from a vocal group of activists and market merchants who call themselves the Friends of the Eastern Market. In recent months the group has fought the renovation plan that earlier this year appeared to have the support of most Capitol Hill community groups.

The Friends maintain that the market should remain as it is with minor fixes and say they have gathered signatures of more than 7,000 city residents who agree with them.

"The Eastern Market is far too important an historical structure to be tampered with in the manner proposed," said Shelley Ross-Larson, a Friends leader and new mayoral appointee to the corporation. She has suggested that the dry goods store be placed in the basement of the market.

Development corporation board members say they are furious that city officials did not alert them to any restraints on their design plan.

"I'm beat. I'm worn out over this. This was a very difficult project," Walker said.

"My time is worth something. I must have spent thousands of hours in the last three years on the assumption that the city was doing what it was supposed to do."