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Berlusconi said he would leave office after parliament approves a budget law that includes reforms demanded by Europe, which is struggling to prevent the debt crisis from spreading to the third largest economy using the euro single currency.

Greece, ground zero of the crisis, is scrambling to win emergency funds to avert bankruptcy as soon as next month, and political parties argued over a new coalition government to replace that of Prime Minister George Papandreou, who has also announced this week that he will step down.

Berlusconi's imminent departure spells the end of the flamboyant billionaire media magnate's 17-year dominance of his country. His failure to implement reforms fueled a party revolt, and votes on the budget measures and his resignation could come as soon as this month.

Berlusconi told his own Canale 5 television station that the only option now was an early election, which could prolong the uncertainty that has sapped market confidence.

President Giorgio Napolitano he would hold consultations on the formation of a new government. Napolitano is thought to favor a technocrat or national unity government for Italy, similar to the solution being put in place for Greece.

That would please markets that have driven the cost of borrowing for Italy's government to 14-year highs. Traders pushed the yield on benchmark 10 year Italian bonds to 6.79 percent, a level unseen since 1997.

Such levels effectively make it unaffordable for Italy to continue to finance its own debt, and are similar to levels that forced Ireland, Greece and Portugal to take bailouts. Italy, however, is widely regarded as being too big to bail out.

Berlusconi's government won a key budget vote on Tuesday after the opposition abstained. But it secured only 308 votes in the 630-seat lower house, eight short of a majority.

Pier Luigi Bersani, leader of the main opposition Democratic Party, said Italy ran a real risk of losing access to financial markets.

"I ask you, Mr Prime Minister, with all my strength, to finally take account of the situation ... and resign," Bersani said immediately after the vote.

ON THE ROPES

The news that Berlusconi had finally agreed to resign came after European markets closed but had an immediate positive impact on markets in the United States. The euro jumped against the dollar and U.S. stocks edged up.

Earlier, Berlusconi's key coalition ally Umberto Bossi, head of the devolutionist Northern League, said Berlusconi should be replaced by Angelino Alfano, secretary of the premier's PDL party. "We asked the prime minister to stand down," Bossi told reporters outside parliament.

The center-left opposition said they abstained to lay bare the weakness of Berlusconi's support while allowing formal ratification of the 2010 budget.

Even when Berlusconi goes, there is no guarantee that reforms to cut the debt mountain and boost growth will be quickly implemented, and relief on markets may not last long. There is no agreement among political parties on either a national unity or technocratic government.

Brussels is putting inspectors in place to help supervise Italian reform. An EU economic surveillance mission will start work in Rome on Wednesday.

Finnish Prime Minister Jyrki Katainen said Italy was just too big to bail out. "It is difficult to see that we in Europe would have resources to take a country of the size of Italy into the bailout program," he told parliament in Helsinki.

LABOURING IN ATHENS

In Greece, the ruling Socialists and the conservative opposition were laboring to agree on a national unity government, expected to be headed by former European Central Bank vice-president Lucas Papademos.

The aim is to establish a "100-day" government to push a 130 billion euro ($180 billion) bailout package, including a "voluntary" 50 percent writedown for private sector bondholders, through parliament before elections in February.

Papandreou, the son and grandson of prime ministers, said farewell to his cabinet at the meeting, a participant said. He asked ministers to tender their resignations.

"Negotiations are being finalized with Papademos as PM," a Socialist party source told Reuters.

However, some politicians in the opposition New Democracy party were resisting an EU demand for a written commitment to the new bailout program with its harsher austerity measures.

Euro zone finance ministers, meeting in Brussels, agreed on Monday on a roadmap for boosting the currency bloc's 440-billion-euro ($600 billion) rescue fund to shield larger economies like Italy and Spain from a possible Greek default.

But with bond investors increasingly on strike, there are doubts about the efficacy of those complex leveraging plans.

In a sign that Italian banks are increasingly shut out of wholesale money markets, the ECB reported they needed 111.3 billion euros in central bank funding in October, up from 104.7 billion euros in September and a mere 41.3 billion in June.

Even the European Financial Stability Facility, the euro zone's bailout fund, had difficulty finding buyers for its top-notch AAA-rated paper on Monday, drawing barely enough bids for 3 billion euros of 10-year bonds issued to support Ireland.

EFSF head Klaus Regling cited a "very difficult" market climate and uncertainty about the fund's future profile as factors in the weak demand.

In Brussels, the 27 European Union finance ministers failed to agree on how to strengthen banks to cope with the sovereign debt shock without halting lending to businesses and consumers.

Options on the table included offering state guarantees to borrower banks or injecting cash into the European Investment Bank, the EU's project finance arm.

(Additional reporting by Emilia Sithole-Matarise in London, Paolo Biondi in Rome, Sarah Marsh in Berlin, Valentina Za in Milan, John O'Donnell and Jan Strupczewski in Brussels, Jussi Rosendahl in Helsinki; Writing by Paul Taylor and Peter Graff)

Investors were encouraged after European Central Bank policymaker Juergen Stark said he sees the crisis over in the next year or so as politicians now realize the need for painful action.

Italian Prime Minister Silvio Berlusconi faced a crucial vote on public finances in parliament that could sink his center-right coalition if enough party rebels desert him. Berlusconi's closest coalition ally told him to resign in what could be a mortal blow to the prime minister.

"That is what we are going to find out. Are these countries too big to save? It all goes back to what is going to happen to the banks balance sheets if sovereign debt is going to have to take a haircut," said Kim Forrest, senior equity research analyst at Fort Pitt Capital Group in Pittsburgh.

In Athens, wrangling continued as politicians tried to form an interim government to save Greece from bankruptcy by enacting a second international bailout plan.

Italian 10-year borrowing costs touched a new record of 6.71 percent on Tuesday, raising the risk that Rome's massive debt -- the second highest in Europe at 120 percent of gross domestic product -- could spiral out of control.

S&P 500 futures rose 9 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 gained 91 points while Nasdaq 100 futures climbed 22.75 points.

European shares rose 1.5 percent, bouncing back from two days of losses, as upbeat corporate news from the likes of telecommunications heavyweight Vodafone Plc (VOD.L) helped offset worries over the debt woes. .EU

Asian shares wiped earlier gains and fell, weighed by concerns about Europe's crisis.

With little on the U.S. economic calendar this week and earnings season near an end, the debt crisis will be at the front of investors' minds.

Hewlett-Packard Co (HPQ.N) is looking to sell its Palm webOS mobile software platform, a deal that could fetch hundreds of millions of dollars but less than the $1.2 billion it paid last year, sources said.

An experimental antidepressant from AstraZeneca Plc (AZN.L) and Targacept Inc (TRGT.O) failed to meet the goal of changing a key depression rating score in a first clinical trial, a setback for both companies.

Targacept shares tumbled nearly 60 percent to $7.69 in premarket trading, and U.S.-listed AstraZeneca (AZN.N) shares lost 2.8 percent to $46.04.

Dynegy Holdings, a unit of energy producer Dynegy Inc (DYN.N), filed for Chapter 11 bankruptcy on Monday, according to court documents. Dynegy shares slumped 13.6 percent to $2.55 in premarket trade.

(Reporting by Chuck Mikolajczak; editing by Jeffrey Benkoe)

Rome has displaced Athens as the epicenter of the euro zone's sovereign debt crisis, with government bond yields nearing unsustainable levels that could force the bloc's third largest economy to seek a bailout that Europe cannot afford.

Italian 10-year borrowing costs touched a new record of 6.71 percent on Tuesday, raising the risk that Rome's massive debt -- the second highest in Europe at 120 percent of gross domestic product -- could spiral out of control.

"Now we are really reaching very dangerous levels ... We are above yield levels in the 10-year where Portugal and Greece and Ireland issued their last bonds," said Alessandro Giansanti, a rate strategist at ING.

Under massive pressure to resign, Berlusconi faced a crucial vote on public finances in parliament that could sink his center-right coalition if enough party rebels desert him.

Five lawmakers in his PDL party said they would abstain, putting Berlusconi's majority in danger. The main opposition parties said they would also abstain, allowing last year's budget to be approved while highlighting the government's weakness.

The 75-year-old billionaire premier, battered by a series of trials and sex scandals, may face a tough confidence vote this week even if he survives on Tuesday.

Euro zone finance ministers, meeting in Brussels, agreed on Monday on a roadmap for boosting the 17-nation currency bloc's 440-billion-euro ($600 billion) rescue fund to shield larger economies like Italy and Spain from a possible Greek default.

But with bond investors increasingly on strike, there are doubts about the efficacy of those complex leveraging plans.

Countries outside the euro area kept up a chorus of pressure for more decisive action to stop the crisis spreading.

"The euro zone needs to show the world it can stand behind its currency, it cannot just wait on developments in Athens and in Rome," British finance minister George Osborne said.

"We must also make progress here in Brussels. If we don't, that will continue to have very damaging effects on the entire European economy."

Swedish Finance Minister Anders Borg added: "Europe is running dry on credibility and a solution to a high debt crisis must be lower debt. The responsibility for that falls with the country with high debt and that is obviously Greece and Italy."

DISTRESS SIGNALS

Distress signals from the bond market and the European Central Bank showed the crisis is gathering pace alarmingly.

Shifts in the Italian yield curve and a widening gap between the prices bondholders demand for Italian debt and what potential buyers are prepared to pay are flashing warning signs similar to those seen in Portugal, Greece and Ireland before high borrowing costs froze them out of debt markets.

In a sign that they are increasingly cut out of money markets, the ECB reported that Italian banks needed 111.3 billion euros in central bank funding in October, up from 104.7 billion euros in September and a mere 41.3 billion euros in June.

Even the European Financial Stability Facility, the euro zone's bailout fund, had difficulty finding buyers for its top-notch AAA-rated paper on Monday, drawing barely enough bids for 3 billion euros of 10-year bonds issued to support Ireland.

EFSF head Klaus Regling cited a "very difficult" market climate and uncertainty about the fund's future profile as factors in the weak demand.

In Athens, wrangling continued to try to form an interim administration to save Greece from bankruptcy by enacting a second international bailout plan before early elections, after Socialist Prime Minister George Papandreou agreed to step down.

Early signs that a deal was within reach on a "100-day" government to push the 130 billion euro bailout, including a "voluntary" 50 percent writedown on Greece's debt to private sector bondholders, through parliament by February appeared to be fading over the choice of prime minister.

Former ECB vice-president Lucas Papademos was in talks with ruling Socialist and conservative opposition leaders on heading the government, but one sticking point was whether members of the main opposition New Democracy party would join the cabinet.

In Brussels, the 27 European Union finance ministers were debating how to strengthen Europe's shaky banks to cope with the sovereign debt shock without halting lending to the "real economy".

Options on the table included offering state guarantees to borrower banks or injecting cash into the European Investment Bank, the EU's soft-loan project finance arm, so that it can lend them more.

A bank recapitalization agreed at last month's EU summit will cost about 100 billion euros, the European Banking Authority (EBA) said, and some countries wanted a more flexible definition of capital to reduce the overall cost.

(Additional reporting by Emilia Sithole-Matarise in London, Sarah Marsh in Berlin, Valentina Za in Milan, John O'Donnell and Jan Strupczewski in Brussels; Writing by Paul Taylor, editing by Mike Peacock)