The prime minister told a cabinet meeting. tasked with approving key measures to rein in the recession-hit country's budget deficit, that no further legislation would be enacted until the political crisis was resolved.
The cabinet had convened to figure out how to delay a controversial planned rise in a sales tax, but escalating tension over former premier Silvio Berlusconi's tax fraud conviction saw it end in disarray.
"I have no intention of limping along or being the subject of continuous threats," Letta said in a statement.
"Either we go forward, and the interests of the country and citizens are put first, or this experience ends here," he said, referring to the uneasy five-month-old coalition between the centre-left Democratic Party (PD) and Berlusconi's People of Freedom (PDL) party.
Letta had "made clear the inescapable need to clarify the political situation in parliament", and therefore a temporary "stop to every government decision, even on tax or economic themes, cannot be avoided," the statement said.
After threats of rebellion from Berlusconi allies over the media mogul's legal problems, Letta spoke of "the impossibility of committing to measures worth billions of euros without a guarantee on the government's continuity."
The premier is expected to ask parliament to assure its support from as early as .
The billionaire's loyalists have threatened to resign if a special Senate committee votes to oust the 76-year-old from his seat in the upper house following his conviction, which was upheld by Italy's top court in August.
The committee is set to meet on , when Berlusconi supporters have announced they will take to the streets of Rome in protest.
Letta has repeatedly called for political stability as the country struggles to emerge from its longest recession since the Second World War.
The International Monetary Fund warned earlier that tensions within the coalition were a "key risk" for the economy.
"The coalition government that took office in April is moving forward on the reform agenda, but faces political constraints," it said in an annual report on the Italian economy.
"While the government maintains support in the parliament, tensions between the coalition partners are apparent and represent a key risk," it added.
Letta's government was cobbled together following a two-month stand-off after an inconclusive general election in February, and while the government has launched major reforms, it has been hobbled by the tensions.
The clash over the sales tax hike is just the latest in a long string of bitter differences.
The PDL has been pushing hard for the government to delay the tax rise, but to do so Italy would need to find over 3 billion euros ($4.05 billion) to plug the gap and bring the deficit inside the EU ceiling.
A plan to fund the delay by increasing fuel taxes sparked anger among members of the centre-right, who said it would punish already hard-hit consumers.
"We cannot accept the blame for this situation. It is not possible to stay in the government if taxes rise and there are no spending cuts," Angelo Alfano, Italy's deputy premier and PDL party secretary, told the cabinet, according to Italian media reports.
"The PD's anti-Berlusconi blindness has got the government into this situation," he was reported as saying." she said.