President Giorgio Napolitano has given Enrico Letta, deputy head of the center-left Democratic Party (PD), a mandate to try to form a new government, according to news wires on Wednesday.
Italy's two-year borrowing costs fell to their lowest point since 1999 on Wednesday ahead of the announcement.
Letta was seen as the favorite to head a grand coalition that Napolitano is expected to announce in a short while. The President summoned Letta to meet him at 11:30 a.m. London time.
After the announcement, Letta said support from other parties was needed and the government would not be "formed at all costs."
He also said he would focus on labor and institutional reforms and criticized the European Union for focusing too heavily on austerity policies.
The selection of a prime minister could bring the two-month long political impasse in the euro zone's third largest economy to an end. Letta must now name his cabinet and the new administration will have to win a vote of confidence in parliament before it can start its tenure.
The FTSEMIB traded lower by 1.1 percent with banks weighing on the benchmark.
(Read More: Italy's Napolitano Speeds Search for New Government)
Silvio Berlusconi's People of Freedom (PDL) party, the center-left Democratic Party (PD) and the centrist Civic Choice movement of outgoing premier Mario Monti have all said they would cooperate with whoever Napolitano chooses.
"Given the crisis the country finds itself in, the country needs a strong, a durable government that can make important decisions," Berlusconi said after meeting Napolitano.
Letta, who is the nephew of Berlusconi's chief of staff, Gianni Letta, has said before he would back any government committed to tackling the "social-economic emergency" and enacting serious political reform, including changes to a dysfunctional electoral law.
(Read More: Hollow Victory for Italy as More Turmoil Looms)
Beppe Grillo, the leader of the anti-establishment "5-Star Movement" told Napolitano it would sit in opposition and may support specific reforms.
On Wednesday, Italy sold 2.5 billion euros worth of two-year zero coupon bonds at 1.17 percent, the lowest yield on its two-year debt since 1999. It also sold the top-planned amount of inflation-linked bonds maturing in 2023, raising 750 million euros.
(Read More: Italy Borrowing Costs Fall on Strong Demand)
"From a reform perspective, Italy is facing the worst of both worlds: no pressure whatsoever from the bond market and the old guard clinging on to power. The former is facilitating the latter," Nick Spiro, head of Spiro Sovereign Strategy, told CNBC on Wednesday.
"The next government is likely to be a conflict-ridden one with very little appetite for reform. The one thing that is likely to keep it from collapsing is the fear that Beppe Grillo's party would perform even better in the next election."
"Berlusconi is the one to watch as he is more keen on a snap election. If the polls are to be believed, the center-right is in a better position now than the center-left was when it was confident of winning February's election," Spiro added.
The 87-year old Napolitano, who reluctantly accepted the role of president for a second term this weekend, berated Italy's politicians at the start of the week by saying their "irresponsibility" had prolonged the country's political deadlock.
Napolitano threatened to resign unless the parties agreed to cooperate on political and economic reforms. The political crisis has shaken the PD party which won the most votes in February's election, with its leader Pier-Luigi Bersani resigning as head of the party after his presidential candidates were rejected by his own party members during elections last week.
-By CNBC's Holly Ellyatt, follow her on Twitter @HollyEllyatt
Reuters contributed reporting to this story.