By Lisa Jucca and Stephen Jewkes
MILAN (Reuters) - Italian shares and bonds lost earlier gains after election projections showed former prime minister Silvio Berlusconi's conservative bloc leading in the Senate, contradicting initial exit polls and raising the specter of deadlock in parliament.
While polls indicated the center-left should win the lower house, projections based on early vote counts from television channels pointed to a victory for media tycoon Berlusconi in the key region of Lombardy, which holds the key to controlling the upper house. The situation remained confused, however.
"I was bowled over by the magnitude of the turnaround. It all seems a bit excessive to me and so I think we should wait," a Milan fund manager said after a buying run immediately after polls showed the left ahead in both houses had been reversed.
"It's clear that from a foreign investor point of view they're very concerned about political instability and forming a government that can push through pro-growth policies in Italy and in Europe," the fund manager said.
"It's an emotive reaction."
State television RAI said Berlusconi's bloc was ahead with 31.6 percent in the Senate, with the center-left at 29.4 percent. Beppe Grillo's protest 5-Star-Movement was at 24.9 percent, on course to be the biggest single party.
The centrist party of technocrat Prime Minister Mario Monti, the darling of international investors, stood at 9.2 percent.
Initial telephone polls published when voting ended at 3 p.m. (1400 GMT) had put the center-left Democrats (PD) on course for full control and the later, conflicting signals led to highly volatile trading as investors fretted over the prospect of political gridlock in the euro zone's third largest economy.
The Milan blue-chip index closed up 0.73 percent at 1630 GMT, having earlier gained nearly 4 percent.
The spread between Italian 10-year government bonds and equivalent German Bunds widened back to 280 basis points after earlier dipping below 255 basis points.
The market had initially soared on hopes of a clear-cut outcome, which would have created scope to push through reforms to revive Italy's recession-hit economy.
"The market's initial reaction was too optimistic. We thought the PD would have won a majority in the lower house, and that's a given. But the Senate is still up in the air, region by region," said Alberto Gallo, credit strategist with Royal Bank of Scotland.
"If the PD gets 156 seats in the Senate but Monti in several regions doesn't win the minimum 8 percent of the vote then even a PD-Monti alliance would have a very thin majority, something which the market would not like."
The euro pared gains against the dollar and the yen in the wake of the Italian election projection, with forex traders closely following political developments in Italy, the euro zone's third-largest economy.
UniCredit, which had led an Italian bank rally with gains of more than 8 percent, erased all gains. Berlusconi's Mediaset, which had suffered losses in the run-up the elections, was up 1.43 percent.
Opinion polls before the vote and a low turnout on the first day of voting on Sunday prompted some traders to place bets already earlier on the day on a victory for the center-left Democratic Party (PD) of Bersani in coalition with Monti.
Heavy snow in several Italian cities and bad weather elsewhere kept some voters away from polling stations on Sunday, when turnout was around 55 percent, down from 62.5 percent at a previous election.
Earlier on Monday, the Italian Treasury paid slightly higher borrowing costs to sell 4.07 billion euros - near the top of its targeted amount - of 2-year zero-coupon bonds and inflation-linked BTPs.
(Additional reporting by Francesca Landini, Silvia Aloisi, Giulio Piovaccari, Danilo Masoni and Jennifer Clark in Milan, and Marius Zaharia in London; Editing by Keith Weir and Alastair Macdonald)