Bailout fund turned into much more ambitious instrument in deal hatched following months of dithering

European leaders have sealed a new €109bn bailout for Greece and erected defences against the debt crisis spreading to Italy and Spain by turning the eurozone's 15-month-old bailout fund into a much more ambitious instrument resembling an infant European monetary fund.

The deal, hatched at an emergency summit in Brussels of eurozone leaders, following months of dithering and division, also entailed large losses for Athens' private creditors, making it almost certain that Greece would become the first eurozone country to be deemed to be in some form of default on its sovereign debt.

A 16-point blueprint provided for a vast expansion in the role and powers of the €440bn bailout fund established in May last year. The package agreed after weeks of bad-tempered, intense haggling and only resolved at the last minute, was the biggest response from the eurozone since it created the bailout fund.

Currently the fund can only be used as a "last resort" to rescue a eurozone country whose plight jeopardises the stability of the euro as a whole.

Under the radical action, the fund will be able to intervene on the secondary markets to buy up the bonds of struggling debtor countries, to take preemptive or "precautionary" action to nip a debt crisis in the bud by, for example, agreeing lines of credit, and to supply loans to struggling eurozone countries who would use the money to shore up and recapitalise their banks. Such aid would apply, unlike at present, to countries not already in bailout programmes.

"By the end of the summer, Angela Merkel and I will be making joint proposals on economic government in the eurozone. Our ambition is to seize the Greek crisis to make a quantum leap in eurozone government," pledged French president Nicolas Sarkozy. "The very words were once taboo. We will give a clearer vision of the way we see the eurozone evolving. We have done something historic. There is no European Monetary Fund yet – but nearly."

While Sarkozy talked up the new powers for the bailout fund, Merkel emphasised that the key aims were to provide relief for Greece's crippling debt burden and to ensure that private lenders to Greece took losses on their investments to that end. "I am satisfied with the result. We showed we're up to the challenge," she said.

Greece's private creditors will take losses of around 20% by agreeing to take part in buybacks of Greek bonds, rolling over Greek debt, or swapping maturing bonds.

"We agree to support a new programme for Greece and to fully cover the financing gap," the eurozone leaders said. "The total official financing will amount to an estimated €109bn."

In addition to that total, the private sector would contribute €37bn, it appeared, although there was some confusion over the precise makeup.

The deal, a trade-off between Germany, which insisted on investor losses, and France, which relishes the greater powers of intervention for the bailout fund, left Jean-Claude Trichet, the head of the European Central Bank, the main loser. He had vehemently opposed Merkel.

The transformation of the bailout fund was directed not so much at Greece as at containing the threat of contagion to other vulnerable eurozone countries, an attempt to curb market uncertainty over the fate of the euro.

The terms of the new bailout, following last year's failed €110bn rescue package, mean that EU leaders are resigned to living with a form of default, however temporarily and however "selectively".

Trichet said that the expected "selective default" would not trigger a credit event, meaning that the debt insurance markets would not face big claims for payouts.

Trichet also stressed that the leaders had offered pledges that Greece was a one-off and that investors would not face losses anywhere else in the eurozone as part of bailout packages.

"As far as private sector involvement in the euro area is concerned, we would like to make clear that Greece requires an exceptional and unique solution," the leaders declared.

Senior German and French bankers briefed the leaders yesterday on various models for private sector involvement. German government sources indicated creditors were writing off 20% of their investments.

Senior eurozone sources said the expected default would last no longer than two months.

The Dutch government said that objections to accepting selective default, mainly from the ECB, had been overcome. Trichet had warned that the bank will no longer keep Greek banks afloat by supplying liquidity for defaulted bond collateral. That role would probably shift, at least temporarily, to the eurozone bailout fund.

"We will provide adequate resources to recapitalise Greek banks if needed," the summit announced.

German government sources said they had received assurances from the international ratings agencies that they would not rush to judgment in declaring a Greek default but would take their time in studying the deal.

The eurozone loans would be provided at interest rates of 3.5%, two points lower than currently, while the maturity of loans to Greece would be more than doubled to at least 15 years and possibly to 30.

There was also good news for Ireland and Portugal, whose borrowing costs for their eurozone bailouts would also fall to 3.5%.