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Still, trading was volatile and volumes were thin as turmoil in Europe's bond markets kept alive fears that the crisis could still engulf Italy.

A brighter picture came from U.S. companies. Merck raised its dividend and Cisco reported strong earnings, reinforcing the view that corporate America is showing strength even as problems in Europe weigh on investors' minds.

Italy paid sharply higher rates for its one-year borrowing, but not as much as some had feared. French bond yields surged amid worries over the country's credit rating.

Standard & Poor's later blamed a technical error for the distribution of a message suggesting it had downgraded France's credit rating. S&P said that was not the case and began an investigation of the matter.

"Our domestic market is solid and showing signs of improvement, but we're not strong enough to ignore what's going on in Europe," said Randy Frederick, director of trading and derivatives for Charles Schwab in Austin, Texas.

"Until we see a viable plan to stabilize Europe, we're going to be hinging on an hourly basis on what's coming out of there. I don't see this going away any time soon."

The Dow Jones industrial average .DJI was up 112.92 points, or 0.96 percent, at 11,893.86. The Standard & Poor's 500 Index .SPX was up 10.60 points, or 0.86 percent, at 1,239.70. The Nasdaq Composite Index .IXIC was up 3.50 points, or 0.13 percent, at 2,625.15.

Merck & Co Inc (MRK.N) gained 3.5 percent to $34.97 after the drugmaker raised its quarterly dividend by 11 percent, its first increase since 2004. The move helped lift the S&P healthcare index .GSPA 1.4 percent.

Cisco Systems Inc (CSCO.O) jumped 5.7 percent to $18.61 and was the Dow's biggest gainer after the network equipment maker's earnings beat estimates and it forecast revenue and profit above expectations.

The CBOE Volatility index .VIX fell 9.2 percent, giving back some of the gains it posted on Wednesday, its biggest day since mid-August. The VIX is up 9 percent so far this week.

U.S. crude oil gained 2.1 percent, helping to lift energy shares. The S&P energy group .GSPE rose 1.8 percent and led all sectors, while industrials .GSPI added 1.1 percent and materials .GSPM was up 0.9 percent.

Oil and gas producer Hess Corp (HES.N) added 4 percent to $63.85, while United Technologies Corp (UTX.N) rose 1.3 percent to $77.47. 3M Co (MMM.N) added 1.7 percent to $80.32.

"These are the names people are gravitating to, because if a recovery comes out of Europe, these industries will be in high demand," said Michael Matousek, senior trader at U.S. Global Investors Inc, which manages about $3 billion in San Antonio.

"However there's still a lot of volatility, and if we drop back under 1,225 on the S&P we'll know there's not a lot of buying power out there."

After the market closed, Walt Disney Co (DIS.N) rose 2.9 percent to $35.65 in extended trading after reporting fourth-quarter revenue that beat expectations.

Nordstrom Inc (JWN.N) sank 4.1 percent to $47.61 after the retailer didn't raise the upper end of its full-year profit forecast.

The S&P 500 fell 3.7 percent on Wednesday, its worst daily percentage drop since August 18. In October, the index recorded its best monthly performance in 20 years on optimism European leaders were taking control of the debt crisis.

Thursday's economic data showed new U.S. weekly jobless claims declined to the lowest level since April, while the trade deficit unexpectedly shrank in September to its narrowest level since December.

Green Mountain Coffee Roasters Inc (GMCR.O) pressured the Nasdaq, sliding 39 percent to $40.89 after its quarterly revenues came in less than expected.

Italy paid its highest yield in 14 years to sell 12-month debt in an auction. Worries remained its borrowing costs were unsustainable.

In Greece, former European Central Bank vice president Lucas Papademos was appointed to head the country's new crisis coalition.

Volume was about 7.3 billion shares traded on the New York Stock Exchange, the American Stock Exchange and Nasdaq, below last year's daily average of 8.47 billion.

More than two stocks rose for every one that fell on the New York Stock Exchange, while on the Nasdaq, 60 percent of stocks closed higher.

(Reporting by Ryan Vlastelica; Editing by Kenneth Barry)

Traders said the European Central Bank increased its bond buying, but the ECB's hard-line chief economist told regional governments not to expect the bank to rescue them with unlimited funds.

A sale on Italian debt went smoothly, but worries persisted that Italy's borrowing costs were unsustainable. The pullback in Italian bond yields helped support market sentiment.

Economic data showed new U.S. jobless claims declined for the second straight week to the lowest level since April, while the trade deficit unexpectedly shrank in September to its narrowest level since December.

"Again, (futures) are being driven by developments in Europe, the fact the Italian debt auction went a little better than expected and the Greeks have finally come together on a prime minister," said Peter Jankovskis, co-chief investment officer at OakBrook Investments LLC in Lisle, Illinois.

"This data that we have on the U.S. is good, but it is hard to deny the overall story is Europe. It's the fact that the yields came down a little bit."

S&P 500 futures rose 15.4 points and were above fair value, a formula that evaluates pricing by taking into account interest rates, dividends and time to expiration of the contract. Dow Jones industrial average futures climbed 144 points, while Nasdaq 100 futures gained 29 points.

The S&P 500 saw its worst daily percentage drop since August 18 on Wednesday. All 10 S&P sectors closed down, with S&P financials .GSPF the hardest hit.

Cisco Systems Inc (CSCO.O) jumped 7.3 percent to $18.89 in premarket trade after the world's biggest networking equipment maker forecast revenue and earnings above expectations for its fiscal second quarter.

After the closing bell, entertainment and media group Walt Disney Co (DIS.N) and graphics chipmaker Nvidia Corp (NVDA.O) are due to post quarterly results.

Disney will seek to reassure Wall Street that global economic woes have not hurt its nearly $11 billion parks and resorts business or held back an advertising rebound at ESPN and its other cable networks.

In Greece, former European Central Bank vice president Lucas Papademos was appointed to head the country's new crisis coalition.

Italy, the region's third-largest economy, has replaced Greece at the center of the European debt crisis storm, with the country's borrowing costs at unsustainable levels and Europe unable to afford a bailout.

(Reporting by Chuck Mikolajczak; editing by Jeffrey Benkoe)

Political and economic turmoil in Rome has spurred fears of a possible break-up of the euro zone with borrowing costs for Europe's third biggest economy at unsustainable levels and the 17-nation currency bloc unable to afford a bailout.

Three senior European Central Bank policymakers rebuffed pressure from investors and foreign governments to intervene massively as a lender of last resort on bond markets to shield Italy and Spain from rapidly spreading financial contagion.

"We have gone pretty far in what we can do but there is not much more that can be expected from us. It is now up to the governments," ECB governing council member Klaas Knot told the Dutch parliament.

Knot, who is also Dutch central bank chief, said bond-buying only had a temporary effect. The ECB has bought more than 180 billion euros of peripheral euro zone bonds and traders said it was active again in the market on Thursday, but the purchases have failed to lower borrowing costs durably.

Stepping up the scale of bond-buying would eventually force the ECB to start printing money with the risk of stoking inflation, which was why the EU treaty had excluded such action, Knot said.

ECB executive board member Peter Praet said it was not the task of the central bank to intervene "when there are fundamental doubts about the sustainability of some countries."

In Brussels, a euro zone official said there were no plans to use the bloc's 440-billion-euro ($600 billion) rescue fund to help Italy, even with a precautionary credit line.

"Financial assistance is not in the cards," the official said. A second official said: "The ECB will be drawn like every one else by the weight of gravity (to act).

Italian 10-year bond yields steadied at around 7 percent, a level seen as unsustainable in the long term, due to signs that the political deadlock may be easing. Rome paid less to sell 1-year treasury bills than many had feared.

Sources in Berlusconi's conservative PdL party said he was convinced it would be better not to call elections at the moment, an abrupt reversal. The billionaire media magnate has agreed to resign within days after parliament approves long delayed economic reforms demanded by European partners.

PdL parliamentary floor leader Fabrizio Cicchitto said the party was now considering supporting a unity government led by former European Commissioner Mario Monti, a respected economist favored by the center-left opposition.

But Berlusconi's populist coalition partner, the Northern League, said it would not back a Monti government.

In Athens, the president's office said Greek party leaders had finally agreed on Lucas Papademos, a former top European Central Bank official, to form an interim government to pull back Greece from the brink of bankruptcy.

The euro rose from a one-month low and world stocks inched up on hopes that new governments being formed in Italy and Greece could help fend off a euro zone break-up.

SMALLER EURO ZONE DENIED

European governments and the EU's executive Commission tried to quash talk of a possible shrinking of the currency area.

EU sources told Reuters on Wednesday that French and German officials had held informal discussions on a two-speed Europe with a more tightly integrated and possibly smaller euro zone and a looser outer circle.

The discussions among senior policymakers, still in the realms of the theoretical, have focused on how to protect the euro zone from breaking up via tighter common policies which some members may by unable or unwilling to live with.

A German government spokesman stressed on Thursday that Berlin was not pursuing the idea of a smaller euro zone. European Commission President Jose Manuel Barroso issued a stark warning of the dangers of a split in the European Union.

"There cannot be peace and prosperity in the North or in the West of Europe, if there is no peace and prosperity in the South or in the East," Barroso said in a speech in Berlin.

German Chancellor Angela Merkel said on Wednesday that Europe's plight was now so "unpleasant" that deep structural reforms were needed quickly, warning the rest of the world would not wait. "That will mean more Europe, not less Europe," she told a conference in Berlin.

She called for changes in EU treaties after French President Nicolas Sarkozy advocated a two-speed Europe in which euro zone countries accelerate and deepen integration while an expanding group outside the currency bloc stays more loosely connected -- a signal that some members may have to quit the euro.

The head of the International Monetary Fund called for political clarity in efforts to tackle Italy's debt crisis, warning that the world could face a "lost decade" if Europe's problems were not tackled boldly.

Uncertainty around who would succeed Berlusconi was fuelling market volatility, Christine Lagarde said on a visit to China.

"No one exactly understands who is going to come out as the leader. That confusion is particularly conducive to volatility," she told a news conference in Beijing. "Political clarity is conducive to more stability and my objective from the Fund's point of view is better and more stability."

Even with the exit of a man who came to symbolize scandal and empty promises, it will not be easy for Italy to convince markets it can cut its huge debt, liberalize the labor market, attack tax evasion and boost productivity.

Euro zone finance ministers agreed on Monday on a road map for leveraging the currency bloc's rescue fund to shield larger economies like Italy and Spain from a possible Greek default.

But markets are running faster than policy and there are deep doubts about the efficacy of those complex leveraging plans, and with Italy's debt totaling around 1.9 trillion euros even a larger bailout fund could struggle to cope.

In Greece, a government official said the new coalition government would be sworn in at 1200 GMT after days of bickering between the ruling Socialists and the conservative opposition bickered over jobs and austerity plans.

Papademos, a respected figure in European capitals and on financial markets, will lead a national unity government that must sign up to a 130 billion bailout deal with the euro zone before calling an early election.

Greece will run out of money in just over a month unless it meets the conditions to receive the next tranche of EU/IMF aid.

(Additional reporting by Dina Kyriakidou, Angeliki Koutantou and Lefteris Papadimas in Athens, Emelia Sithole-Matarise, Kirsten Donovan and William James in London, Barry Moody and Alberto Sisto in Rome; Writing by Paul Taylor; Editing by Mike Peacock)

European stocks were up slightly in morning trade after reversing sharp losses in morning trade, with Italian shares rallying on fresh hopes the country will have a new government soon while the European Central Bank was reportedly buying the country's bonds to ease the tensions surrounding its debt pile.

German and French officials have discussed plans for a radical overhaul of the European Union that would involve setting up a more integrated and potentially smaller euro zone, EU sources say.

Cisco Systems Inc (CSCO.O) will be in focus after the group forecast revenue and earnings above Wall Street expectations as demand from government and enterprises for its network equipment remained resilient despite global economic troubles.

Shares of Cisco traded in Frankfurt (CSCO.F) were up 2.4 percent.

Boeing (BA.N) will also be in focus, after rival Airbus parent EADS's (EAD.PA) stock surged 5.5 percent following results and an outlook that reassured investors.

Global industrial group Siemens AG (SIEGn.DE) said it will pay a smaller-than-expected 11 percent increase in its full-year dividend and gave a cautious outlook after ending its year in a turbulent economic environment.

Deutsche Telekom (DTEGn.DE) still expects to close the sale of its T-Mobile USA unit for $39 billion to AT&T (T.N) on schedule, Telekom Chief Executive Rene Obermann said on Thursday.

Goldman Sachs Group Inc (GS.N) and Morgan Stanley (MS.N) are discussing whether to reduce their use of mark-to-market accounting, in which companies immediately take profits or losses as asset values fluctuate, the Wall Street Journal said.

Alabama's Jefferson County filed for bankruptcy court protection on Wednesday in the biggest municipal bankruptcy in U.S. history.

World oil demand will be lower than expected this year and next as economic slowdown and high prices curb consumption, the International Energy Agency (IEA) said on Thursday.

U.S. stocks tumbled 3 percent on Wednesday in the market's worst day since mid-August as a spike in Italian bond yields signaled the European debt crisis had worsened.

The Dow Jones industrial average .DJI was down 389.24 points, or 3.20 percent, at 11,780.94. The Standard & Poor's 500 Index .SPX was down 46.82 points, or 3.67 percent, at 1,229.10. The Nasdaq Composite Index .IXIC was down 105.84 points, or 3.88 percent, at 2,621.65.

(Reporting by Blaise Robinson; Editing by Hans-Juergen Peters)

The euro was steady, after suffering its biggest daily drop in 15 months on Wednesday, while industrial commodities such as copper and oil softened on worries of renewed recession. European shares were set to extend the previous day's losses.

Asian credit spreads blew out as the deepening crisis in Europe sapped investor appetite for risk, while safe haven assets such as Japanese government bonds were in demand.

"Whatever they come up with, it doesn't avoid a European recession," said Su-Lin Ong, senior economist at RBC Capital Markets in Sydney.

"The question now is just how deep it will be and whether this is going to bleed over into the banking system, because that is much more significant."

FINANCE SECTOR HAMMERED

Tokyo's Nikkei share average fell 2.9 percent, while MSCI's broadest index of Asia Pacific shares outside Japan lost 3.5 percent, with the financial and industrial sectors hammered hardest.

Hong Kong's Hang Seng Index, the Asian market that has tended to be most susceptible to European developments in recent months, was the biggest regional loser, falling 4.5 percent as banks such as HSBC led losses.

Financial spreadbetters expected Britain's FTSE 100 to open down 1.5 percent, while Germany's DAX and France's CAC-40 were called down 1.7 percent.

Italy has, for the time being, replaced Greece as the biggest source of concern in Europe's two-year-old debt crisis.

Italian 10-year bond yields rose above 7 percent on Wednesday, a level most market economists consider unsustainable for financing debt of more than 2 trillion euros.

A pledge by Italian Prime Minister Silvio Berlusconi to stand down failed to reassure bond markets that Rome has the will to bring its debts under control, and moves by two major clearing houses to raise the level of collateral needed for holders of Italian debt pushed the country near breaking point.

European and U.S. stocks fell steeply on Wednesday in response, with Wall Street shares losing more than 3 percent. S&P 500 futures traded in Asia were up slightly on Thursday.

TOO BIG TO BAIL

Ireland and Portugal were both forced to seek aid soon after their 10-year bond yields topped 7 percent, but a rescue for Italy would be on a different scale and Europe's bailout fund is widely considered inadequate for the task.

The European Central Bank (ECB), considered the only institution capable of repelling the bond market attacks, bought Italian bonds in substantial amounts on Wednesday, but is reluctant to go further to force down yields.

"The markets were basically in a panic yesterday and the only thing that can give the euro at least a temporary respite is quick action from the ECB to lower Italian yields," said Koji Fukaya, chief currency strategist at Credit Suisse in Tokyo.

While many outside Europe are calling on the ECB to take a more active role, as other major central banks do, in acting as lender of last resort, Germany remains implacably opposed to what it views as a threat to the central bank's independence.

In a sign of the depth of fear gripping European capitals, EU sources told Reuters that French and German officials had held discussions about a euro zone split.

The single currency was steady around $1.3540, after tumbling around 2 percent on Wednesday.

The dollar was also steady against a basket of currencies, after surging in the previous session as investors scurried for safety, while yields on 10-year Japanese government bonds fell 1 basis point to 0.965 percent.

In Asian credit markets, spreads widened around 13 basis points on the Asia ex-Japan iTraxx investment grade index, a gauge of risk appetite.

Concerns about flagging demand knocked London Metal Exchange copper down 2.4 percent. U.S. crude oil edged down to $95.70 a barrel, while Brent crude dipped a touch to around $112.26.

"We've moved from a low-growth scenario to one where there is a real threat of recession in the euro zone, and that's weighing on oil markets," said Ric Spooner, chief market analyst at CMC Markets in Sydney.

(Additional reporting by Miranda Maxwell in Melbourne and Antoni Slodkowski in Tokyo; Editing by Richard Borsuk)