The prime minister's bitterly divided Liberal Democratic Party, which has governed for most of the past half century, is also in danger of losing at the polls for the powerful lower house, politicians and analysts say.
Takenori Kanzaki, leader of junior ruling coalition party, the New Komeito, said after meeting Koizumi on Monday the election would be held on 11 September, infuriating party rebels who had said Koizumi should resign instead.
"There is no justification. It's like suicide bombing," said LDP lower house lawmaker Housei Norota, who had opposed the bills to privatise Japan Post, a sprawling giant that has some $3 trillion in assets and includes the world's biggest deposit-taking institution.
Koizumi called an emergency cabinet meeting on Monday, and ministers - with one dissenting vote - decided to dissolve the lower house of Parliament, Foreign Minister Nobutaka Machimura said.
The order was later read by lower house speaker Yohei Kono at a specially called session, after which the disbanded lawmakers filed out of the chamber.
"I assume the prime minister made a difficult decision," Machimura said. "He had said he would dissolve the lower house if the bills were voted down, so I supported his decision."
The defeat of the legislation raised concerns in financial markets that the reforms Koizumi pledged to implement when he swept into power in 2001 would stall.
"It's a very sad day for the reform story of Japan, because with this vote, it's essentially over and the effects of this will be felt in the years to come," said Kirby Daley, a strategist at Societe Generale Securities' Fimat division.
Others were less pessimistic.
The bills were rejected in the
upper house by 125 to 108 votes
"Koizumi tried to achieve reform within the LDP framework. He said that was possible. But he couldn't do that, so that means reform is only possible if there is a change in government," said Yasunori Sone, a political science professor at Keio University.
The bills were rejected in the upper house by a vote of 125 to 108. Reports said more than 20 LDP members had voted against the legislation.
The spectre of political confusion in the world's second-biggest economy also made financial markets nervous.
The yen and Japanese share prices fell when the results of the vote became known. The Japanese currency quickly recovered most of its losses, however, and the Nikkei share average was later trading in positive territory well above the day's lows.
The bills would have split Japan Post into four units under a state-owned holding company in 2007. Insurance and savings businesses were to have been sold off by 2017.
Koizumi, who leapt to power promising reform and is now Japan's longest-serving prime minister in two decades, had said privatisation was vital to make investment flows more efficient and remove distortions from the financial system.
Japan Post's insurance business alone is as big as the country's four biggest life insurers combined.
Analysts say the opposition
Democratic Party may win
But many in the LDP feared privatisation would weaken their political machines, which have long relied on powerful rural postmasters to get out the vote and on the postal system's assets to fund popular but wasteful public works.
Japan Post has nearly 25,000 offices and 260,000 employees.
Scenarios for political confusion following the defeat abound, including the mirror image of a 1993 drama in which pro-reform rebels bolted the LDP and the party lost an election and was ousted, albeit briefly.
This time, though, the rebels are anti-reform.
Analysts say the centrist main opposition Democratic Party has a shot at winning an election, but it would need help from other parties to get legislation through the upper house.
"With the split of the LDP, the Democrats stand to gain. But they need a big victory," Sone said. "They need to win a majority.
"That's more difficult, but this is a huge chance."
LDP anti-reformers have threatened to form a new party, although they might cooperate with the LDP. Coalition partner New Komeito has hinted it may switch sides if the Democrats become the top party but lacked a majority.