Italian Prime Minister Enrico Letta said he would go before parliament on Wednesday for a confidence vote after ministers in Silvio Berlusconi's center-right party pulled out of his government at the weekend.
Letta said he wanted to avoid elections under the current widely criticised voting system which he said would produce more stalemate but said there were signs that dissenters in Berlusconi's People of Freedom (PDL) party could support him in a confidence vote.
"I hope that there is a part of the PDL which is not in accord with Berlusconi,'' he told RAI state television.
President Giorgio Napolitano said he would only dissolve parliament as a last resort but just seven months after the last vote it is not clear if an alternative majority can be found.
Berlusconi, the center-right former prime minister who was forced out of office in November 2011 at the height of the euro zone debt crisis and faces a ban from parliament for tax fraud, has already launched his election campaign.
Infighting among the left-right coalition government has thwarted efforts to push through reforms Italy needs to emerge from a two-year recession, a 2-trillion-euro public debt and youth unemployment of around 40 percent.
The political paralysis resulting from the government's collapse will delay those reforms even further in the euro zone's third largest but most sluggish economy.
"It is tradition for the president to dissolve parliament early when it isn't possible to create a majority and a government for the good of the country," Napolitano told reporters ahead of his meeting with Letta.
The prime minister will address parliament on the crisis early next week.
Berlusconi said he decided on the shock move on Saturday after the government's failure to avert a long-programmed hike in sales tax at a cabinet meeting the day before.
Letta dismissed the motivation as a "huge lie," saying instead that the media tycoon, who celebrated his 77th birthday on Sunday, was acting out of fury at his impending expulsion from parliament following a conviction for tax fraud.
"Markets have grown accustomed to Italy's dysfunctional politics but there's a sense that things are now spinning out of control, with potentially dangerous consequences for both Italy and the eurozone," said Nicholas Spiro, head of Spiro Sovereign Strategy.
(Read more: Italy in crisis as Letta struggles to secure budget)
With fears that markets will punish Italy for the political turmoil, all eyes now are on whether Napolitano can muster backing either for a second Letta government or for an administration led by another figure.
If not, Italy would be forced to return to the polls with a major risk that, with a dysfunctional electoral law and three parties of roughly equal size, they would produce a hung parliament and yet more instability.
Berlusconi on Sunday called for new elections, but there were signs that some allies may not be willing to follow him.
Hopes of Letta or another figure being able to govern in the present parliament may depend on there being sufficient numbers of rebel lawmakers from Berlusconi's People of Freedom (PDL) party, which he recently re-named Forza Italia (Go Italy!).
Constitutional Reforms Minister Gaetano Quagliariello and Health Minister Beatrice Lorenzin on Sunday both said they would resign but not be part of the nascent Forza Italia, while Infrastructure Minister Maurizio Lupi warned that the new party risked being "extremist."
Another long-time Berlusconi loyalist, Fabrizio Cicchitto, expressed rare dissent over the way Berlusconi had withdrawn his ministers without party consultation.
Whether these misgivings develop into a full blown revolt remains to be seen and will be crucial to the prospects of avoiding an election.
Letta has a commanding majority in the lower house, and if he can gain support from a few dozen Senators among Forza Italia or opposition groupings such as the anti-establishment 5-Star movement, he could form a new government.
(Read more: (Read more: Silvio Berlusconi's 'greatest' hits)
"The only path to follow is to go with determination towards new elections," Berlusconi told a party gathering in Naples in a telephone link-up. "I am convinced that a government of taxes is not in the interests of our country."
Economy Minister Fabrizio Saccomanni played down the risk that Italy's borrowing costs would shoot up when markets open on Monday, a danger highlighted by other cabinet members.
"I think the uncertainty connected to the government's instability has been largely already factored in during the last few weeks," he told business daily Il Sole 24 Ore.
Italy's borrowing costs hit a three-month high at an auction of 10-year bonds on Friday, while the premium investors demand to hold Italian debt rather than German paper widened to about 267 basis points from under 250 at the start of the week.
Saccomanni's deputy Stefano Fassina warned on Sunday that benchmark bond yields would rise by up to 300 basis points if new elections were called.