By Allison Lampert and Ana Mano

MONTREAL/SAO PAULO (Reuters) - Canada insisted on Friday that it plays by international trade rules after Brazil warned it may challenge government funding to planemaker Bombardier Inc, a move that would revive a two-decade-old dispute between the two countries.

The Montreal-based company is locked in competition with Brazil's Embraer for narrowbody jet sales. The South American country has said that government financing gives Bombardier an unfair advantage.

Brazilian Foreign Minister Jose Serra told Reuters on Thursday it could move against Canada at the World Trade Organization (WTO) over $1 billion in funding that Bombardier received from the Canadian province of Quebec for its CSeries jet.

Canadian Prime Minister Justin Trudeau brushed off the suggestion, telling reporters "there is no country in the world that doesn't heavily subsidize its aerospace sector."

"I can understand that our competitors are rightly worried about how great the CSeries plane is," he said in Calgary.

The Brazilian minister responded in a statement on Friday evening that Trudeau's comments were revealing.

"It's telling that the Canadian Prime Minister admits the Canadian government heavily subsidizes Bombardier," Serra said.

Embraer estimates that Bombardier received a total of $3.5 billion in state support, he noted. Embraer imports equipment from Canada to build jets and the subsidies hurt trade flows, he said.

Brazil and Canada have locked horns repeatedly at the WTO over the past 20 years over state support for Embraer and Bombardier, the world's biggest commercial planemakers after powerhouses Boeing Co and Airbus Group.

Ottawa is also considering whether to match Quebec's investment in the CSeries program, which ran years late and billions of dollars over budget.

Embraer's concerns boiled over in April when Bombardier won a deal to provide 75 CSeries to U.S. carrier Delta Air Lines Inc, beating Embraer's E190 family of jets with what many industry watchers saw as an aggressive bid.

Industry sources involved in negotiating similar deals have estimated that discounts as high as 75 percent might have been offered to reboot the CSeries program with the order, matching some of the most aggressive pricing in the market.

Embraer complained at the time that it was "not competing with a private enterprise anymore."

A Bombardier executive said on Friday that Embraer was likely worried about competition from the 110-150 seat CSeries program, which has 325 firm orders and made its first scheduled commercial flight on Friday.

"They have seen our airplane go through the certification process and now enter into service. There is certainly a lot more competition and they are probably concerned about what the CSeries means for their business," said Ross Mitchell, a vice president of commercial operations for Bombardier.

Embraer has 272 firm orders for its estimated 100-130 seat next-generation E-Jets. Its E190-E2 is scheduled to enter service in 2018 while the E195-E2 jet is expected to begin commercial flights in 2019.

Embraer has asked the Brazilian government to monitor any funding Ottawa gives Bombardier, an Embraer spokesman said, adding the planemaker was "capable of competing against any companies, but not against the government of Canada."

Quebec's equity stake in the CSeries, first agreed to in 2015, is more difficult to challenge than a straight export subsidy arrangement, said trade lawyer Mark Warner at MAAW Law in Toronto.

Quebec government spokeswoman Melissa Turgeon said in an email that the province has analyzed these questions. "We know we are respecting international trade rules," she said.

However, Embraer could raise questions about Delta buying CSeries jets at heavily discounted prices, especially since Bombardier had not signed a single deal for the planes in more than a year before the ones with Delta and Air Canada in 2016.

Brazil's threat of a challenge could scare away potential customers who see risks to future funding for Bombardier from Canadian governments.

"Most people don't like messy situations," Warner said.

Competition between Bombardier and Embraer is expected to intensify as carriers like American Airlines retire their E190s in the next few years and could consider small narrowbodies to fill mainline routes.

Air Canada ordered the 45 CSeries jets to replace its E190s.

(Additional reporting by David Ljunggren in Ottawa, Nia Williams in Calgary, Jeffrey Dastin in San Francisco, and Tatiana Bautzer in Rio de Janeiro; Editing by Chizu Nomiyama and Richard Chang)