Italy was firmly in the eye of the eurozone debt storm on Monday as it became the target of potentially self-fulfilling fears that it will be unable to pay off its huge public debts.

In an attempt to stem selling surges in the bond and equity markets, Italy's finance minister, Giulio Tremonti, promised to "send the markets a strong signal". He said a package of measures to reduce the budget deficit would be "armour-plated" and approved by parliament within a week: "Something that has never happened in the history of Italy."

The German chancellor, Angela Merkel, said she had discussed the situation on Sunday with Italy's prime minister, Silvio Berlusconi. She told a press conference in Berlin that Italy had to agree "on a budget that meets the need for frugality and consolidation", adding: "I have full confidence the Italian government will pass exactly this kind of budget."

Concern over the effectiveness of the package was central to the sell-off of Italian shares and bonds that began on Friday. But neither Tremonti's nor Merkel's words managed to stem the panic. The yield on benchmark 10-year government bonds soared to 5.565% – the highest since May 2001 – which sharply increases the state's borrowing costs. At one point, the spread between the Italian benchmark bond and its German equivalent reached a record 290 basis points.

The concern over bonds infected the stock market where Italian banks, leading holders of their country's debt, were particularly badly hit. Intesa SanPaolo's shares lost more than 7.5% as the FTSE MIB index of Milan bourse blue-chips slid 3.9% by the close of business.

One of the concerns driving markets was that the return on Italy's bonds could reach a level that was unsustainable for its treasury. The rise in yields, in effect the interest rate Italy must pay to borrow, comes at a particularly awkward moment: Bloomberg estimated last week that between now and the end of 2012, the government will have to refinance 26% of its public debt.

The Italian state's accumulated borrowing has risen to almost 120% of GDP – the second highest level in the EU after Greece. As part of a programme for its reduction, Tremonti last week unveiled a four-year, €40bn-plus (£32bn) package of deficit-cutting measures.

But, with Berlusconi's coalition partners in the Northern League clamouring for tax cuts to buy back the government's lost popularity, all but €6bn of the adjustments were postponed. Fears that the package could be watered down – or that Tremonti may not be around to see them through – contributed to a growing sense of unease among investors.