Events in Athens gathered speed a day after Papandreou held a bruising meeting in France with German and French leaders, who told him Athens would not receive a cent more in aid until it voted to meet its commitments under the bailout deal.
"I will be glad even if we don't go to a referendum, which was never a purpose in itself. I'm glad that all this discussion has at least brought a lot of people back to their senses," he said in the text of a speech to his cabinet released to media.
"If the opposition comes to the table to back the bailout, a referendum is not needed.
Both the conservative opposition and some lawmakers within Papandreou's socialist party PASOK demanded some kind of unity government which would push through parliament the 130 billion euro rescue, Greece's last financial lifeline.
Under intense pressure at home and also from the leaders of Germanyand France, Papandreou softened his insiste
nce that the Greek people should decide in a referendum on whether to accept the bailout, which also demands yet more austerity.
Conservative leader Antonis Samaras led calls for a new government. "I'm asking for the formation of a temporary, transitional government with an exclusive mandate to immediately hold elections. And the ratification of the bailout deal from the current parliament," he said in a statement.
Papandreou responded by welcoming the decision by Samaras to drop his previous opposition to the bailout package, which euro zone leaders agreed only last week as they tried to prevent the bloc's debt crisis running out of control.
Papandreou reiterated that Greece's euro zone membership was not in question and that heading to elections immediately would entail a big risk of the country going bankrupt.
Greeks have fiercely opposed the spending cuts, tax rises and job losses which have been the price of financial aid from the IMF and European Union to tackle its huge debt and budget deficit. This has led to a wave of strikes and outbreaks of violence on the streets of Athens.
A spokesman for the New Democracy party said a transitional government should not be composed of party politicians. He declined to elaborate.
However, the idea appeared to be gaining ground within Papandreou's own socialist party PASOK.
A small group of senior PASOK lawmakers are preparing a proposal for a coalition government headed by former European Central Bank Vice President Lucas Papademos, a Greek, party sources told Reuters.
Government officials said Papandreou, who also called a vote of confidence in his government for Friday, was not resigning and would await the result of the talks with New Democracy.
"There is no resignation by the prime minister. He will speak, as scheduled, in parliament later on Thursday," one official told Reuters.
Finance Minister Evangelos Venizelos broke ranks with Papandreou, coming out against holding the referendum after the meeting with the German and French leaders.
"REFERENDUM IS DEAD"
Chaos over Greece's role in the euro zone swept financial markets with early losses in stocks and the euro turning to gains on hopes Athens might ditch its referendum plans.
The Greek stock exchange rose 5 percent on speculation the referendum would be abandoned, with the index of bank shares soaring 15 percent. World stocks as measured by MSCI gained 0.9 percent after earlier being sharply lower.
In Europe, the FTSEurofirst 300 lost 1 percent initially but later stood close to 1 percent higher. Earlier, Japan's Nikkei closed down 2.2 percent.
"The referendum is dead," Greek ruling party lawmaker Nikos Salayannis said on state radio.
One PASOK lawmaker said she would not support the government in the parliamentary vote of confidence on Friday, cutting its majority for that vote to just one.
PASOK has 152 deputies in the 300-member parliament.
Lawmaker Eva Kaili announced she would stay in the party but refused to support the government in the confidence vote expected late on Friday, meaning Papandreou could count at most on the support of 151 deputies.
Venizelos, one of the most powerful men in the PASOK government, originally supported Papandreou's plan. His change of mind came after he and Papandreou attended the emergency summit in Cannes on Wednesday with Merkel and Sarkozy.
A finance ministry source told Reuters on condition of anonymity that Venizelos believed the vote on the bailout, which was agreed by euro zone leaders only last week, should not be held while immediate funding to keep Greece afloat still had to be secured.
A VERY DIFFICULT MEETING
"Under these conditions a referendum is exactly what the country does not need. He would not have objections if all our pending issues such as the loan installment and the completion of the bailout plan had been sorted out," the source said after the meeting with Merkel and Sarkozy.
"It was a very difficult meeting," the source added.
Papandreou's bombshell announcement on Monday of the referendum pitched Greece into a political as well as an economic crisis.
About 10 PASOK lawmakers have publicly called for a coalition government to approve the EU bailout deal and proceed to new elections. About 15, including five ministers and deputy ministers, have rejected the referendum idea.
PASOK lawmaker Costas Gitonas said the referendum should not take place. "No, by no means," he told Mega TV. "It's a madhouse."
The specter of a precipitous Greek default and euro exit hung over a meeting of G20 leaders beginning in Cannes on Thursday.
The French Riviera summit had been meant to focus on reforms of the global monetary system and steps to curb speculative capital flows, but the shock waves from Greece have upended the global talks.