By Giuseppe Fonte and Barry Moody
ROME (Reuters) - Silvio Berlusconi's party withdrew its support for Prime Minister Mario Monti on Thursday, raising the risk of a snap election in Italy, but President Giorgio Napolitano said he would work to avoid a crisis and there was no need for alarm.
The centre-right People of Freedom (PDL) party walked out of a Senate confidence vote on a package of economic measures and abstained in a separate confidence vote in the lower house following criticism of Berlusconi by a senior minister.
Monti's government survived comfortably but the risk it could fall remained as tensions rose between the parties that have backed the technocrat government over the last year.
Head of state Napolitano, who makes the final decision on whether to call an election, said there was no need for alarm on international markets and Italy's institutions were strong.
"There are pre-electoral political tensions that even outside Italy can be understood without creating alarm about the institutional strength of the country," Napolitano said.
PDL secretary Angelino Alfano said the party had not wanted to bring the government down on Thursday but would decide over the next few days whether to do so. "If we had wanted to make it fall, we would have already today given a vote of no confidence," he told reporters.
If the government does fall, an election would likely be called only a few weeks earlier than the expected date in early March, but such a development would upset investors nervous about what will follow Monti.
With all parties now clearly in campaign mode, Alfano said that Berlusconi had told him of his intention to run following strong indications on Wednesday that he would return to the frontline as the PDL election candidate.
The PDL move on Thursday followed comments by one of Monti's ministers saying Berlusconi's return could be bad for Italy.
Napolitano said a turbulent end to the five-year legislature must be avoided so Monti's government could complete its program and the prime minister said he would await the president's judgment on Thursday's political drama. The president will meet Alfano on Friday.
Napolitano has previously said he will not call elections until parliament has approved a package of economic reforms.
The political confusion helped drive up Italian bond yields but the impact was relatively contained. The premium investors demand to hold Italian 10-year BTP bonds rather than lower-risk German Bunds widened to 330 basis points, having fallen below 300 points earlier in the week.
International markets are worried about what will happen after Monti steps down. The respected former European Commissioner has restored confidence in Italy since he took over a year ago from the flamboyant and scandal-plagued Berlusconi.
The centre-left Democratic Party (PD), which is the main element with the PDL of a cross party alliance sustaining Monti, indicated it could ask Napolitano to dissolve parliament if the government could not count on the support of Berlusconi's party.
The conflict underlined the deep uncertainty in Italian politics before next spring's election and weakened bond prices, which have come back under control since reaching critical levels before Monti's takeover.
Berlusconi's statement on Wednesday suggested that he wanted to exploit public anger over austerity measures to revive the fortunes of the party he founded and bankrolled, which has slumped badly in opinion polls over the last year.
The former premier said the situation was much worse than when he stepped down and Italy was on the edge of an abyss.
In a television interview early on Thursday, Industry Minister Corrado Passera expressed strong reservations about a return by the 76-year-old billionaire, who left office last year as investors despaired of him addressing the country's economic crisis and Italy seemed headed for a Greek-style crisis.
The stand-off deepened the confusion surrounding the election and threatens to open a severe political crisis in the euro zone's third largest economy.
Berlusconi accused Monti's government of dragging Italy into an "endless recessive spiral". Passera retorted that most of Italy's deep economic problems were the result of a decade of poor management.
Berlusconi, who was in power for most of the past 10 years, faces deep divisions within the PDL, which is split between loyalists opposed to Monti and other factions, including many who want to continue backing the government's reform agenda.
Former Foreign Minister Franco Frattini, a leading PDL moderate who wants Monti to come back as premier after the election, defied party orders to abstain in the lower house vote, together with at least three other deputies.
Analysts say the party could easily fall apart before the election, leaving a void on the centre-right which has already lost substantial ground to the populist 5-Star Movement of comedian Beppe Grillo which is second in opinion polls after the centre-left.
Disillusioned PDL supporters are also believed to be a substantial bloc of the up to 50 percent of voters who say they would abstain in an election or have not made up their minds.
Berlusconi's indecision has further undermined his party, whose support is now at less than half the level that won it a landslide election victory in 2008.
(Additional reporting by Paolo Biondi, Giuseppe Fonte, Massimiliano Di Giorgio, Steve Scherer, Catherine Hornby, James Mackenzie and Naomi O'Leary; Editing by Jon Hemming)