By James Mackenzie
ROME (Reuters) - Italian Prime Minister Enrico Letta returned to Rome on Friday preparing for a showdown over the future of his warring coalition government following threats by Silvio Berlusconi's centre-right allies to walk out of parliament.
Letta's left-right coalition has flirted with collapse ever since Italy's top court convicted former premier Berlusconi of tax fraud last month and sentenced him to four years in prison, commuted to a year of house arrest or community service.
On Wednesday, parliamentarians in Berlusconi's People of Freedom party (PDL), partners in the coalition, said they would resign en masse if a Senate committee meeting on October 4 votes to begin proceedings to expel their leader from parliament.
Letta, who returned from New York where he had been courting foreign investors, is due to meet President Giorgio Napolitano for talks on the increasingly tense situation which could force him to call a vote of confidence in parliament.
"The situation is sliding towards elections," Maurizio Gasparri, deputy PDL floor leader in the Senate told RAI state television. "We are in a dramatic, critical phase," he said.
The political convulsions in the eurozone's third largest economy have increasingly worried investors, although with the European Central Bank guaranteeing stability in the markets, there has been none of the panic seen during previous crises.
At an auction of 10-year bonds on Friday, Italy's borrowing costs rose to their highest level in three months, while the premium investors demand to hold Italian debt rather than AAA-rated German paper widened to 267 basis points from under 250 at the start of the week.
Napolitano, who issued a sharp rebuke to Berlusconi on Thursday, accusing his allies of undermining the functioning of parliament, said he could not say whether the parties would act responsibly to head off the crisis.
CABINET MEETING POSTPONED
Letta met Angelino Alfano, his deputy prime minister and the national secretary of the PDL, for the first time since the latest crisis broke out as pressure grew for a clear end to the months of infighting which has hobbled the government.
"It's a moment when we need clarity, there's no time for hypocrisy and clever tricks," Dario Franceschini, the centre-left minister for relations with parliament told reporters.
Whether the threats from the centre-right amount to more than bluff remains to be seen, with the party split between hardliners pushing for a break with the government and more cautious moderates in favor of compromise.
However, the frenetic political maneuvering has held up any prospect of reform to Italy's stumbling economy, now in its second year of recession.
A cabinet meeting, which had been expected to agree around 3 billion euros worth of budget cuts to help bring Italy's deficit under the European Union's limit of three percent of output was postponed until Friday evening.
The meeting, which could be delayed further until the weekend, will be the last chance for the government to agree measures to avert a one percentage point increase in sales tax, scheduled to begin in October.
The tax has been one of the latest points of contention between Letta's centre-left Democratic Party (PD) and the PDL, which has repeatedly said it will pull out of the government if the planned increase goes ahead.
(Additional reporting by Francesca Landini; Editing by Alastair Macdonald)