Algirdas Brazauskas, who leads the Social Democrats, said in a statement: "The prime minister does not see any possibility of continuing his work and resigns. The government resigns along with him."
The Labour party was the biggest in the coalition government that withdrew.
Analysts said they expected lengthy efforts to build a new coalition, with the possibility of fresh elections if that proved unsuccessful.
Whatever government emerges, little change is expected in the foreign policy of the Baltic state, which joined the European Union and Nato in 2004.
The crisis was triggered by allegations of the misuse of party and state funds by senior Labour party figures. The health minister told BNS on Tuesday he had spent party funds on repairing his car after a crash.
State investigators have also found that the culture minister broke ethics rules by paying family travel expenses from state funds.
Valdas Adamkus, the Lithuanian president, said on Tuesday that he had lost confidence in the two ministers, both from the Labour party whose leader, Viktor Uspaskich, a Russian-born businessman and former energy trader, was forced to resign from his post of economy minister last year because of a breach of ethics rules.
Uspaskich, who has investments in agriculture, is known throughout Lithuania as the Gherkin King.
Adamkus discussed the crisis with Brazauskas on Wednesday morning.
The government, the 13th since the ex-Soviet state won independence in 1991, had been in power for just under two years but had been shaky for months because of political rivalry between Labour and its coalition partners.
Uspaskich is leader of the
Lithuanian Labour party
The government also suffered a serious blow when the European Commission and the European Central Bank this month rejected its plan to adopt the euro at the start of 2007 because of high inflation.
Labour had 31 seats in the 63-seat minority government in a parliament comprising of 141 seats. The ruling coalition comprised Labour, the Social Democrats and the Peasants party.