The prospect of elections as early as September, with the prospect of eurosceptic parties strengthening their position, hit markets.
Italy's benchmark FTSE MIB sank in morning trade, down 3%. The UK's FTSE was down 1.37%, Germany's Dax down 1.85%, and France's Cac down 2%.
And the sell-off in Italian bonds deepened, with the yield on two-year debt breaking through the 2% barrier.
The yield on the bond is set for its biggest one-day jump in 26 years.
Movements in bond prices are important as they affect the cost of borrowing for the government. Italy's debt currently stands at 130% of its economic output.
The bond sell-off hit the share price of Italian banks exposed to government debt, with Intesa Sanpaolo, BPER Banca, Unicredit and UBI Banca falling sharply.
Meanwhile the pan-European Stoxx 600 fell 1.6%, with banks the worst-performing shares, and the euro fell against the dollar and pound.
'Troubles deepen'
The turmoil was precipitated after the anti-establishment Five Star and League political parties abandoned their attempts to form a ruling coalition after a standoff with President Sergio Mattarella.
He had vetoed their choice of a eurosceptic economy minister, and appointed former International Monetary Fund official Carlo Cottarelli as interim prime minister with the task of trying to form a government.
But his term is likely to be cut short, as he will almost certainly lose a parliamentary vote of confidence. If he does, then new elections would soon follow.
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