By Dina Kyriakidou and Harry Papachristou
A leading lawmaker from Papandreou's socialist party quit while two others said Greece needed a government of national unity followed by snap elections, which the opposition also demanded.
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The leaders of France and Germany scrambled to limit the damage to the wider euro zone, and European politicians expressed incredulity at an announcement that caught everyone by surprise -- including Papandreou's own finance minister.
"It's difficult to see what the referendum is going to be about. Do we want to be saved or not? Is that the question?" asked Swedish Foreign Minister Carl Bildt.
Business executives in Greece expressed despair at how the country was being run and markets speculated on whether Italy will be the next euro zone country to slide into a debt crisis.
Jean-Claude Juncker, who chairs meetings of euro zone finance ministers, refused to rule out a Greek debt default.
"The Greek prime minister has taken this decision without talking it through with his European colleagues," he said in Luxembourg.
Asked whether a Greeks "no" vote would mean bankruptcy for Greece, Juncker responded: "I cannot exclude that this would be the case, but it depends on how exactly the question is formulated and on what exactly the Greeks people will vote on."
Papandreou, whose PASOK party has already suffered several defections as it pushes waves of austerity measures through parliament while protesters rally in the streets, said he needed wider political backing for the budget cuts and structural reforms demanded by international lenders.
But his problems deepened dramatically after his announcement on Monday. A cabinet meeting was due to held later on Tuesday.
PASOK lawmaker Milena Apostolaki quit the parliamentary group on Tuesday, reducing Papandreou's strength to just 152 seats out of 300 deputies before a vote of confidence.
"It's my duty to resist this wrong political choice which divides in an effort to replace the popular mandate and threatens the country's viability," Apostolaki wrote in a letter to the president of parliament.
"These are crucial moments and citizens need to be represented by members of parliament they have elected. Therefore... I am becoming independent."
Fellow PASOK lawmaker Vasso Papandreou demanded a new government to ensure Greece receives the 130 billion-euro rescue deal agreed at a euro zone summit only last week.
"I am calling on the President of the Republic to convoke political leaders with the object of forming a government of national unity to safeguard the aid package decided on October 27 and call elections immediately afterwards," said Papandreou.
Papandreou did not even inform his Finance Minister, Evangelos Venizelos, he was going to announce the referendum on the latest EU aid deal, a Greek government official said.
"Venizelos had no idea about the referendum. All he knew about was the vote of confidence," the official told Reuters on condition of anonymity.
"THEY MUST BE CRAZY"
"They must be crazy... this is no way to run a country," said the senior executive of one of Greece's biggest firms, speaking on condition of anonymity.
Elsewhere in the euro zone, politicians complained Athens was trying to wriggle out of the bailout package, concerned not so much about the fate of Greece as the possibly dire consequences for the entire currency union of the referendum.
Ireland, which itself took a bailout, attacked Papandreou's idea.
"The summit last week was to deal with the uncertainty in the euro zone...and this grenade is thrown in just a few short days later," European affairs minister Lucinda Creighton said.
"Legitimately there is going to be a lot of annoyance about it," she told Reuters.
The Greek opposition demanded a snap election and financial markets, which had calmed down after euro zone leaders agreed the second Greek bailout, took Papandreou's bombshell badly.
Shares in banks dived, investors fled to the safety of German bonds and Italian borrowing costs climbed despite European Central Bank action. Investors speculated that Italy might follow a similar path.
One senior German parliamentarian suggested the euro zone might cast Athens adrift, cutting off its aid lifeline and allowing the nation to default on its huge debts.
"This sounds to me like someone is trying to wriggle out of what was agreed -- a strange thing to do," said Rainer Bruederle, a leader in Merkel's coalition.
Bruederle, parliamentary floor leader for the Free Democrats and a former German economy minister, said he was irritated by Papandreou's announcement.
Europe would have to consider turning off the flow of money which is keeping Greece afloat, he told Deutschlandfunk radio.
"One can only do one thing: make the preparations for the eventuality that there is a state insolvency in Greece and if it doesn't fulfill the agreements, then the point will have been reached where the money is turned off," he said.
On the markets, players scurried for safer investments, hammering stocks and punishing the euro.
The FTSEurofirst 300 index of top European shares was down almost four percent, due not only to the possibility of a disorderly Greek default but chaos surrounding the euro zone's attempts to stop the debt crisis spreading to more significant economies such as Italy.
Euro zone banks exposed to Greece and Europe's bigger, troubled economies, suffered particularly. Shares in France's Societe Generale tumbled 17 percent and Credit Agricole was down almost 12.5 percent.
Andrew Lim, banking analyst at Espirito Santo in London, said that a Greek "no" vote could trigger a "hard default", forcing banks to take losses of about 75 percent on their Greek sovereign bonds and raising the threat of a systemic risk.
"If we get a hard default in Greece, it will exacerbate the situation with Italy and Spain. It just increases the problem of Italy going down the same route, and that's the real risk," Lim said.
Investors sold off bonds issued by Italy and Spain -- two major economies with debt problems which would be much tougher to rescue than Greece, one of the euro zone's smallest members.
Traders said that prompted the ECB to step in and buy the bonds of both countries as implied Italian borrowing costs hit a three month high around 6.26 percent.
In Athens, the conservative opposition leader called for snap elections. "Elections are a national necessity," conservative leader Antonis Samaras told reporters.
Germans on the streets of Berlin expressed exasperation with the entire euro project.
"All I understand is that the Greeks keep causing us problems. We'd be better off without the euro," said Bert Kuehn as he delivered rolls to a bakery.
Analysts said the latest opinion poll showed a majority of Greeks took a negative view of the bailout deal.
The renewed uncertainty is likely to be an embarrassment for G20 leaders meeting in France this week trying to coax China into throwing the euro zone a financial lifeline.
Greece is due to receive an 8 billion-euro tranche in mid-November, but that is likely to run out during January, around the time of the referendum, leaving the government with no funds if there is a "no" vote.
A survey carried out on Saturday showed that nearly 60 percent of Greeks viewed the agreement on the bailout package as negative or probably negative.
(Additional reporting by Ingrid Melander and Renee Maltezou in Athens, Michele Sinner in Luxembourg, Carmel Crimmins in Dublin, Fiona Ortiz in Madrid, Jeremy Gaunt, Adrian Croft and Marius Zaharia in London, Jussi Rosendahlm in Helsinki and Erik Kirschbaum and Madeline Chambers in Berlin; Writing by Dina Kyriakidou and David Stamp)