Five ministers from Silvio Berlusconi's centre-right political party have resigned, effectively bringing down the government of Enrico Letta, the current prime minister.
Talks will now start to find a new parliamentary majority to back a new cabinet and avoid going back to elections just seven months after the last one.
The political jockeying that has defined Letta's five-month tenure has already thwarted efforts to push through important reforms that Italy needs to emerge from a two-year recession
Italy is also suffering from a decade-long economic slump, a 2tn-euro public debt and youth unemployment of around 40 percent.
Saturday’s resignations by the People of Freedom (PDL) party ministers will delay those reforms even further.
They came a day after Letta challenged the PDL to support him in a confidence vote in parliament.
Late on Friday, the cabinet failed to agree vital fiscal measures to bring the budget deficit within EU limits, leaving the fragile coalition of traditional rivals from the left and right near total breakdown.
Tensions between the two sides had been rising for weeks following moves to expel Berlusconi, a former prime minister, from parliament after his conviction for tax fraud last month.
The Friday cabinet meeting had been intended to find funding to avert an increase in sales tax from 21 percent to 22 percent.
That increase, which has been fiercely opposed by the PDL, will now kick in from Tuesday.
"The decision taken by Prime Minister Enrico Letta to freeze government activities, and therefore setting off an increase in sales tax, is a serious violation of the pacts on which this government was formed," Berlusconi said in a statement on Saturday.
Letta responded later in the evening, accusing Berlusconie of telling a "huge lie" and of using the sales tax issue as an alibi for an action motivated by his legal problems.
PDL legislators this week threatened to walk out of parliament if a Senate committee meeting on October 4 voted to begin proceedings to expel their leader under legislation that bars convicted criminals from parliament.
Some opposition politicians called for early elections, but Stefano Fassina, deputy economy minister and a member of Letta's Democratic Party, said he expected a new coalition could be formed.
Letta has a commanding majority in the lower house, and if he can gain support from a few dozen senators among the PDL or opposition groupings such as the anti-establishment 5-Star movement, he could form a new government.
President Giorgio Napolitano, who has to either call new elections or oversee the creation of a new coalition and subsequent government, gave renewed signals on Saturday that he did not want the country to return to the polls.