"We have decided to vote for confidence, not without internal disputes," Berlusconi said ahead of a confidence vote in parliament called after he
launched his challenge to the leadership on Saturday.
Berlusconi said he had changed his mind on Wednesday after hearing Letta's promise to lower taxes and "the need for a government that can carry out
institutional reforms in Italy".
The surprise about-turn made victory for Letta's coalition a certainty and was immediately cheered by the markets, with shares in Milan jumping 1.45
percent higher after the shock announcement.
The difference between rates on Italian 10-year government bonds and benchmark German ones – a measure of investor confidence – also narrowed to
253 basis points from 260 points on Tuesday.
Letta shook his head as Berlusconi was speaking and the address was followed by stunned silence.
Lawmakers were still set to vote despite the change of heart by a man who has dominated Italian political life for much of the past two decades.
Letta earlier asked lawmakers to vote for him, saying Italians were tired of "blood in the arena".
"Italy runs a risk that could be a fatal risk. Seizing this moment or not depends on us, on a yes or a no," Letta said in his address to the Senate.
"This is an historic situation," he said.
Several key figures from Berlusconi's own centre-right People of Freedom party (PDL) broke ranks with the billionaire media mogul after his decision to
call time on the government and pull his ministers from the cabinet on Saturday.
Letta immediately condemned the move as "crazy and irresponsible" and Interior Minister Angelino Alfano, national secretary of Berlusconi's party,
reacted by saying he would be "pro-Berlusconi in a different way".
A letter doing the rounds in the Senate just before Berlusconi spoke had 23 signatures of PDL senators willing to defy their leader.
Together with votes from four rebels of the anti-establishment Five Star Movement, this would have been sufficient for Letta to win a majority even
without Berlusconi's support.
"Italians are crying out that they cannot take any more blood in the arena, with politicians who slit each other's throats and then nothing changes," said
Letta, a 47-year-old moderate leftist.
'Confidence boost for Italy'
Berlusconi had only on Tuesday rallied his supporters to vote against the government.
"Despite the risks, I have decided to put an end to the Letta government," Berlusconi had said in a letter to the Catholic magazine Tempi.
Tensions within the coalition have spiked since Italy's top court upheld a tax fraud conviction against Berlusconi in August, which could see him ejected
from the Senate later this month and barred from taking part in the next elections.
Financial analyst Christian Schulz from Berenberg Bank said a Letta victory "would be a confidence boost for Italy and the eurozone."
"Italy would avoid the power vacuum ahead of new elections, could address the fiscal slippage and reassert confidence that the Eurozone is on the mend," he said.
But analysts warn recession-hit Italy's fiscal policy targets are still at risk and the political drama could delay the 2014 budget.
The country is suffering the longest downturn since the Second World War and is struggling to meet a public deficit target of 2.9 percent for this year
– below the EU-mandated 3.0 percent.
The jobless rate has also returned to a record high of 12.2 percent, with youth unemployment also at its highest ever level of 40.1 percent.