By Lilla Zuill and Jonathan Stempel

NEW YORK (Reuters) – An $85 billion government rescue of insurer American International Group Inc looked increasingly likely on Tuesday to stave off a bankruptcy that would have thrown world markets back into turmoil.

The Federal Reserve will extend AIG $85 billion in exchange for a nearly 80 percent stake to bail out the troubled insurance giant, a person briefed on the matter said.

The deal would avoid the biggest corporate bankruptcy ever and follows a government bailout of mortgage lenders Freddie Mac and Fannie Mae just over a week ago.

Earlier, U.S. stocks clawed back from their biggest one-day drop in seven years, soothed by speculation about a government rescue of AIG, a likely sale of Lehman Brothers’ investment bank to Britain’s Barclays, and a better-than-expected quarterly profit from Goldman Sachs.

Morgan Stanley added a positive note after the close of trading when it reported a slight quarterly profit fall, setting it apart from rivals bleeding red ink.

Then AIG shares, which had sunk 21 percent in regular trading, fell as much as 48 percent in after-hours dealings after reports of a rescue that could wipe out shareholders.

The New York Times, which had reported that AIG could file as soon as Wednesday for bankruptcy protection, later reported the deal with the Fed.

“This would mean another shareholder wipeout,” said David Ader, head of government bond strategy at RBS Greenwich Capital in Greenwich, Connecticut.  Continued…