The U-turn by the embattled premier was announced during an emergency cabinet meeting on Thursday and followed a high-pressure meeting with Nicolas Sarkozy, French president, and Angela Merkel, German chancellor in which the offer of a €8bn loan from the EU was temporarily withdrawn.
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Defending his decision Mr Papandreou said: “We had a dilemma: consensus or a referendum … Failure to back the package would mean the beginning of our departure from the euro. But if we have consensus, then we don’t need a referendum.”
Mr Papandreou had been preparing to resign at a cabinet meeting earlier in the day, but the offer was withdrawn after he secured the backing of the opposition party for last week’s €130bn EU bail-out, which would result in a 50 per cent loss for holders of Greek sovereign debt.
Antonis Samaras, leader of the opposition New Democracy conservative party, said he would be willing to back the new bail-out agreement in order to ensure Greece stays in the euro.
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The Conservatives opposed Greece’s previous bail-out on the ground that harsh austerity measures would deepen the country’s recession and leave banks without liquidity to fund investment.
The outcome of the high-stakes brinkmanship in Athens was welcomed by investors and helped equity markets rally across Europe and the euro move higher against the dollar.
Mr Papandreou and Mr Samaras were both due to address parliament later on Thursday.
The dramatic developments in Greece came as the European Central Bank reacted to the escalating eurozone crisis with a surprise interest rate cut after its first council meeting chaired by Mario Draghi, its new president.
The decision to lower the main policy rate from 1.5 per cent to 1.25 per cent follows mounting evidence that the eurozone is heading into recession, with its economic outlook darkened by the uncertainty over Greece.
Earlier, worries about a disorderly Greek default have helped to drive Italian bond yields rose to fresh euro-era highs. Italian 10-year bond yields rose to 6.399 per cent on Thursday, while the extra premium the country pays over Germany jumped to 459 basis points. Splits in heavily-indebted Italy’s cabinet on Wednesday prevented agreement on a package of economic reforms.
The drama in Athens dominated preparations for the G20 summit. Mr Sarkozy, the meeting’s host, said the situation was “very charged”, with leaders preoccupied by the Greek crisis.
The country is not expected to default in the next few weeks as the next round of debt redemptions starts on December 19. But without the funds, the government would be unable to pay more than 700,000 public sector workers and more than 2m pensioners at the end of the month. It has already started postponing payments to suppliers, officials said.
Civil servants were due to stage another anti-austerity protest outside parliament on Thursday. Officials from their union, Adedy, said the latest round of pay cuts had reduced average public sector salaries by more than 20 per cent.
“We will send the message to the government that we have reached the limit of what we can take, “ a union official said.
Additional reporting by Hugh Carnegy in Cannes and David Oakley and Tom Burgis in London