Margaret Thatcher warned Charles Haughey during a series of heated exchanges that Irish unity would spark the worst civil war the world had ever seen.
The two leaders - desperate to improve Anglo-Irish relations in the wake of several atrocities in Northern Ireland and a major extradition row - clashed repeatedly over security issues.
Mr Haughey bluntly warned the Conservative leader: "If you keep on belittling what we are doing, we lose heart. We get no credit for what we are doing."
However, Mrs Thatcher said Ireland had the greatest number of terrorists in the world outside of Lebanon.
Government papers released in Dublin today - marked 'Most Secret' - detailed hard-hitting exchanges during a summit meeting in Hanover, Germany, on the fringes of the European Council on June 28, 1988.
The meeting took place after the killing of three IRA members in Gibraltar by the SAS, the Milltown Cemetery attack by loyalist terrorist Michael Stone, and the execution of two corporals who were attacked, stripped and beaten by a mob after driving into a republican funeral cortege.
Two of the incidents unfolded in front of TV cameras.
"On devolved government, the world's harshest battles are not between black and white but between people who are like each other and who live beside each other like the Greeks and Turks, the Seikhs and Hindus, the Arabs and the Israelis," Mrs Thatcher warned. They keep their hatred alive.
"I will never be prepared to walk out and let the terrorists win.
"You talk of unity and I ask would that be better? I say: 'No' - there would be the worst civil war in history - and it would spread to the mainland."
The Taoiseach repeatedly tried to interrupt the Prime Minister to stress that his Government had "expressed our horror" at atrocities over the border and was doing its best to improve security co-operation.
However, Mrs Thatcher said recent events had made Northern Ireland a byword for terrorist outrages.
She, in other documents, warned there were times when Northern Ireland made her "berserk", such was the sheer savagery of the violence.
Secret documents revealed she admitted watching the footage of the incident involving the two Army corporals.
Derek Wood and David Howes had driven into the funeral cortege of Caoimhin Mac Bradaigh, who had been killed by Stone during his attack on mourners at the Gibraltar Three funerals in Milltown Cemetery.
When they tried to reverse away, their car was blocked and then surrounded.
The two soldiers were overpowered, dragged from the car, beaten and then driven away from the scene.
They were stripped and then executed by an IRA unit.
Their desperate attempt to get their vehicle away from the funeral cortege was caught by TV cameras.
Reports released in Dublin indicated Mrs Thatcher was horrified by what she witnessed on television.
"The savagery was unbelievable - and don't think the people who did it were contrite. Not the least bit," she told Mr Haughey.
Three months later the IRA used Libyan Semtex to blow up a van used by off-duty soldiers involved in a fun run in Lisburn. Six were killed.
In a letter to Mr Haughey, Mrs Thatcher said she appreciated the sympathy of the Irish Government.
But she said she wanted greater intelligence sharing.
"Their importance and urgency need no emphasis given the sharp rise in IRA attacks in the past few weeks and the quantities of arms now in their hands," she said.
She added: "We are facing a major terrorist offensive and it is crucial we step up our joint efforts to counter it."