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* President tasks Conte with forming a 5-Star/PD cabinet
* Conte headed the previous 5-Star/League coalition
* 5-Star online referendum could sink the proposed pact
* Markets rally on hopes of new government (Adds more Conte quotes, details)
ROME, Aug 29 (Reuters) - Italy's president asked Giuseppe Conte to head a coalition of the 5-Star Movement and opposition Democratic Party (PD) on Thursday, a move could that could mark a turning point in Italy's frayed relations with the European Union.
Sergio Mattarella handed Conte a fresh mandate to form a cabinet barely a week after the low-key lawyer had resigned following a decision by the far-right League party to pull out of its coalition with 5-Star.
The move by its leader Matteo Salvini, who had wanted early elections to capitalise on his party's success in European elections, appeared to have backfired as 5-Star and the PD set aside their mutual antipathy to form a government.
"In the coming days I will return to the president of the republic ... and submit my proposals for ministers," Conte told reporters at the presidential palace.
"We must immediately get to work and draw up a budget to avert the VAT hike, protects savers and offers solid prospects for economic growth and social development," he said. VAT will rise from Jan. 1 unless the government can find 23 billion euros ($26 billion) elsewhere.
Markets have been buoyed by the prospects of a quick end to a three week political crisis. Italy's 10-year borrowing costs fell to an all-time low at auction on Thursday as investors hailed news that early elections have been avoided.
However, the incoming coalition still needs to agree a shared policy platform and team of ministers. In a further complication, 5-Star has said it will put any deal with the PD to an online vote of its members. Many 5-Star supporters oppose a pact with the centre-left and a 'yes' vote is not a certainty.
BUDGET A PRIORITY
Conte, an academic with no political affiliation but considered close to 5-Star, said that work on the 2020 budget was his priority.
In an early, basic draft of a coalition policy platform, the two sides would ask the EU for flexibility on the 2020 budget deficit to "reinforce social cohesion" in the country, financial daily Il Sole 24 Ore said on Thursday.
The EU imposes budget rules on member states with the aim of ensuring financial stability in the bloc. It has had a testy relationship with Rome under the outgoing administration, with League leader Salvini blaming the EU rules for impoverishing Italians.
Salvini had promised swingeing tax cuts for 2020 that economists warned could put unsustainable pressure on Italy's towering debt mountain.
The prospect of a new administration led by Conte, who was considered a voice of reason within the 5-Star/League coalition, has lifted markets. Investors are betting that Italy will get a fiscally prudent government that will avoid confrontation with Europe.
Italy's battered blue-chip index was heading for its best weekly performance in six months, gaining 2% to nearly cover all of this month's losses. If the gains are sustained, Italy would be the only index in Europe to finish the month in positive territory.
In the bond market, the spread between Italian and German 10-year debt was at 166 basis points, it's tightest since May 2018.
"We think it will be less challenging to agree on an agenda between M5S (5-Star) and PD because the priorities both political forces have set out seem broadly consistent in many areas, ranging from fiscal policy to Italy's relationship with the EU to a focus on a green economy," UBS Wealth Management Italy's Matteo Ramenghi said. ($1 = 0.8973 euros)
(Writing by Crispian Balmer; additional reporting by Valentina Consiglio, Gavin Jones in Rome; Editing by Jon Boyle)