After several days of sniping at each other, Olmert and Labour leader Amir Peretz announced on Tuesday they would work towards forming a coalition which will still need the support of several other smaller parties.
"We are glad to announce that, after President Moshe Katsav appoints me to form a government, we will start coalition talks to create a government in which Labour will be a senior partner," Olmert told a joint press conference.
The president now believes that Olmert is the best placed to form the next coalition because he commands the support of the majority of the 12 parties who won seats in the 17th Israeli parliament, a spokeswoman said.
Following Kadima party's victory in last week's general election, Olmert has pledged to set the final borders of Israel by 2010 - with or without agreement from the Palestinian Authority.
With Kadima holding only 29 of the 120 seats up for grabs, Olmert will have to cobble together a broad coalition willing to pull some 70,000 Israelis out of the occupied West Bank in exchange for permanent control over large blocs where most of the quarter of a million-strong settler population lives.
Peretz, who had earlier touted the possibility of forming his own government even though his centre-left Labour won 10 mandates less than Kadima, said there was a "new basis for co-operation between Labour and Kadima".
At the press conference, Peretz said: "A government led by Kadima and its chairman Ehud Olmert will be stable and able to hold the full-year term and set short and long-term goals," he said at the press conference."
Tuesday's developments came as Ariel Sharon, Israel's coma-stricken prime minister suffered a fresh setback hours before he was to undergo skull surgery.
Surgeons had been due Tuesday to carry out a delicate task of restoring part of Sharon's skull, which was removed in initial surgery.
However, they were forced to postpone their plans after the patient was discovered to have developed "a slight infection" in his respiratory tract.
A spokesman at the Hadassah hospital in Jerusalem played down the seriousness of the infection and said Sharon's status remained "serious but stable".