By Catherine Hornby
ROME (Reuters) - Italian Prime Minister Enrico Letta met with a top official from Silvio Berlusconi's center-right party on Monday to try to defuse a row which is threatening to bring down his fragile ruling coalition and has rattled financial markets.
Relations between Berlusconi's People of Freedom (PDL) party and Letta's center-left Democratic Party (PD) are increasingly tense ahead of a vote on whether to expel the media mogul from parliament over his tax fraud conviction, and because of a disagreement over a property tax.
The spat between the unwilling coalition partners has reignited fears of fresh political instability in the euro zone's third-largest economy as it struggles to emerge from a two-year recession, sending shares and bonds lower.
A top PD official on Monday accused the PDL of "blackmail" after several of its members threatened to bring down the government if the PD voted to expel Berlusconi from the Senate in a ballot due by October.
"The PD rejects any blackmail or ultimatum from the PDL," PD Secretary Guglielmo Epifani told the daily newspaper La Repubblica on Monday, reaffirming that his party would vote in favor of Berlusconi's removal from parliament.
"Berlusconi needs to take note of what led to his conviction, and he has to explain why he would bring down the government at a time of crisis."
He warned that if the government collapsed just as Italy was showing the first signs of recovery after its longest postwar recession, there would be "enormous costs" for society and renewed tremors in financial markets.
Italy's main stock market index, fell 2 percent, with shares in Berlusconi's Mediaset hitting a six-week low. The main index of broader investor sentiment, the spread between Italian 10-year bond yields and their safer German equivalents widened to 250 basis points.
"It doesn't look like the politicians will find a compromise to get out of this crisis, which puts all measures that need to be taken to spur the economy on ice," said a Milan trader.
"There is the risk that this could hit our economic recovery at a time when the country has shown some signs of a pick-up," he said.
The parties are also divided over economic reforms and tax issues, notably a widely hated housing tax which the PDL says must be scrapped despite fears this could blow a hole in Italy's fragile public finances.
Letta, appointed to lead the cross-party coalition after inconclusive elections in February, is trying to push on with measures to spur growth and fight record levels of unemployment but has struggled to pass any meaningful reforms in the face of deep divisions in the government.
On Monday, he met PDL secretary Angelino Alfano, along with Economy Minister Fabrizio Saccomanni and Regional Affairs Minister Graziano Delrio, to try to seek agreement on the housing tax issue, which has dogged the government for months.
Berlusconi's own party is struggling to contain internal tensions between members pushing for compromise with the PD and those who want to pull the plug on Letta.
On Monday, Berlusconi ordered supporters not to make any further public statements that could damage party unity.
The billionaire has been holed up in his luxury villa near Milan since early August when Italy's supreme court handed him a four-year jail sentence, commuted to one year, for a massive tax fraud at his Mediaset empire.
He is desperately trying to find a way to stay in the political game despite the sentence, which he is expected to start serving either under house arrest or doing social work, in mid-October.
The supreme court decision is not Berlusconi's only legal headache. He is also appealing in a lower court against a seven-year jail sentence imposed in June for abuse of office and paying for sex with a minor.
The cabinet is due to meet later on Monday to agree on measures to cut public administration spending.
(Additional reporting by Agnieszka Flak, Editing by James Mackenzie and Raissa Kasolowsky)