By Jeremy Gaunt, European Investment Correspondent
The threat of a Greek exit from the euro hung over a meeting of G20 leaders after France and Germany made it clear that Athens must decide urgently whether it wants to stay in the 12-year-old currency bloc.
Greek Prime Minister George Papandreou was under the gun, losing support within his own party, after calling for a referendum which will test his highly-indebted country's resolve to stay in the currency bloc.
Speculation was rising that there would be an election rather than a referendum.
"People are thinking Papandreou's government falls and therefore the referendum is postponed, but it's obviously wishful thinking because it doesn't fix any issues," said one trader at a European investment bank.
For investors, the referendum has raised the specter of a disorderly default on Greek debt with the real threat being a spillover into other countries, notably Italy.
"There is massive uncertainty. Is Greece going to come out of the euro?" said Andrea Williams. who manages $2.1 billion in assets for Royal London Asset Management.
"We are trying to avoid exposure to domestic Europe, we were concerned about European growth anyway, but now it is going to be absolutely dreadful. We are trying to avoid anything with over-exposure to Italy and Spain."
World stocks as measured by MSCI were flat after earlier being sharply lower. Emerging markets fell 1 percent.
In Europe, the FTSEurofirst 300 <.FTEU3> lost 1 percent initially but later stood close to 1 percent higher. Earlier, Japan's Nikkei <.N225> closed down 2.2 percent.
The renewed Greek crisis, beginning only days after a supposedly comprehensive European Union agreement to fix the debt problem, has brought a gradually improving investment climate to a sudden halt.
U.S. Fed Chairman Ben Bernanke sought to soothe market tensions on Wednesday, promising to do more if necessary to boost the U.S. economy.
Attention was also on the European Central Bank meeting later on Thursday, the first under new ECB President Mario Draghi.
The euro recovered earlier losses, but was considered vulnerable as a result of the uncertainty about Greece remaining in the bloc.
It was at $1.37, boosted by repatriation flows. But the trend was tenuous.
"Depending on whether there is a referendum or not I would not be surprised to see the euro trade down to the $1.33/$1.34 area in the next two to three weeks," said Jeremy Stretch, currency strategist at CIBC.
The premiums investors have to pay to hold Italian and French 10-year government debt over benchmark German Bunds rose to their highest in the euro era.
(Additional reporting by Jessica Mortimer, Joanne Frearson and Simon Jessop; editing by Stephen Nisbet)