A return to direct rule from London is a possibility if the Northern Ireland parties fail to agree on a plan to resolve deep disagreements over paramilitarism and welfare reform, the cabinet minister for the province has warned.

Secretary of state Theresa Villiers told the Conservative party conference on Wednesday the survival of devolved government was now at stake in the talks going on in Belfast between unionist and nationalist parties.

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Villiers said “a return to direct rule would be a severe setback” but admitted transferring powers back to London cannot be ruled out.

Northern Ireland’s power-sharing government is under threat over two key issues: the alleged ongoing existence of the Provisional IRA and the Ulster parties’ inability to reach consensus on welfare reforms.

Unionists have latched on to an assessment by the Police Service of Northern Ireland that the PIRA still exists in some form and that some of its members were behind the murder of ex-PIRA prisoner Kevin McGuigan in August. They claim this breaches a key article of faith in agreements that led to them sharing power with nationalist party Sinn Féin – the dissolution of the PIRA as a military force and the decommissioning of its weaponry. Sinn Féin has countered that unionist threats to pull down power sharing are due to inter-unionist election rivalry.

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Even before the McGuigan murder controversy, however, there were deep divisions inside the power-sharing coalition at Stormont over Treasury demands for cuts to the public-sector workforce in Northern Ireland. The two main unionist parties and the centrist Alliance party supported the welfare reform programme while Sinn Féin and the SDLP have opposed it. As a result, the Northern Ireland Executive has been unable to set a budget this year.

Concentrating on the row over welfare reform, Villiers said: “One only has to look round Europe to see the problems caused when an administration cannot live within its budget and the harsh impact that can have on some of the most vulnerable in society.

“Replaying that scenario in Northern Ireland would stretch political relationships within the Executive well beyond breaking point. There’s a real risk that those taking a hard line against welfare reform will end up running the devolved institutions into collapse as collateral damage.”

Transferring power from the Stormont government in the region back to Whitehall would mark a major blow to the agreements negotiated over the last 17 years aimed at restoring devolution to the province. It would enrage nationalists in particular, and lead to a bitter election contest for a new Stormont assembly in either late autumn or early winter.

The main unionist party, the Democratic Unionists, has also received sustained criticism over its partial boycott of Northern Ireland Executive business. Even though the DUP ministers are absenting themselves from cabinet meetings, it has emerged they are still taking their full salaries as if they were fully in government.

In response to charges of hypocrisy, the DUP said on Wednesday its ministers will not personally gain financially from the payments while their “in-out” protest over alleged ongoing PIRA activity continues.