France and Germany battle to save the single currency as Europe is plunged back into turmoil days after rescue deal

The French president Nicolas Sarkozy and German chancellor Angela Merkel will hold emergency talks on Wednesday in a desperate attempt to hold the eurozone together and formulate a response to the Greek prime minister's plan for a referendum on the austerity measures imposed by his European partners.

George Papandreou's socialist government is on the brink of collapse after his referendum plan sparked an angry reaction within his own party and plunged Europe back into turmoil, just days after a complex rescue deal had been agreed – requiring Greece to embark on tough cost-cutting measures.

While Papandreou's cabinet approved unanimously his decision to hold a referendum, it threatens to split the prime minister's Pasok party. One MP, Milena Apostolaki, has quit in disgust at the idea of a referendum and several colleagues have said that if it is not abandoned they will join her. Papandreou faces a vote of confidence on Friday. A split in the Pasok party would almost certainly bring down the Greek government, which now has a majority of just two MPs in parliament.

The Greek finance minister, Evangelos Venizelos, who was rushed to hospital after the referendum announcement, said Papandreou had kept him in the dark over his plan to announce a vote.

As global markets tumbled, Papandreou assembled his cabinet, allowing his ministers to air their views on his surprise decision to call the vote. He told them the referendum remained the only way of overcoming public opposition to the spending cuts agreed as part of the eurozone rescue package. "Everything now rests on the vote of confidence."

He predicted that any stock market turmoil would be shortlived, adding: "No one will be able to doubt Greece's course within the euro." Late last night his cabinet colleagues unanimously backed his referendum decision.

Stock markets had reacted with alarm to the prospect that the €1tn deal to rescue the euro currency union was in danger of collapse. The FTSE 100 closed down 2.2% at 5421 after an initial fall of 5%. The German Dax index and French Cac remained 5% down at the close, while the Dow Jones closed down almost 2.5%.

Sarkozy and Merkel have arranged a meeting on Wednesday evening with officials from the EU and IMF, which has already lent money to Greece and is involved in talks about further rescue funds. The meeting will take place in Cannes hours before both leaders are due to meet Barack Obama, who is flying to France for the G20 summit, which begins on Thursday. Obama wants the eurozone countries to end the uncertainty and agree a sustainable financial package.

After Greece, Italy is seen as the most vulnerable to a lending boycott by international investors, following a series of broken promises on reforms by the prime minister, Silvio Berlusconi. The Italian president, Giorgio Napolitano, added to the febrile atmosphere by saying it was his duty to verify whether the conditions were in place for reforms to be implemented. The statement, couched in highly formal terms, appeared to indicate that Napolitano would consider a new government, with representatives from outside Berlusconi's centre-right coalition.

German officials, visibly angry at the prospect of a referendum, said a no vote in the referendum could plunge Greece into bankruptcy and force it out of the eurozone. German newspapers asked if their government, which has committed the largest contribution to the bailout fund, should maintain its support.

Michael Roth, Europe spokesman for the opposition Social Democrats in Berlin, said Papandreou's move showed courage but he was "playing with fire". He said: "If the Greeks are not ready to support Papandreou's reforms, Greece faces an uncertain future in Europe."

The rescue deal that Papandreou now intends to put to the vote will allow Greece access to €130bn of extra funds needed to maintain public spending and pay wages following a 50% write-off of its debts.

A €1tn firewall of insurances and guarantees is also intended to protect Italy and Spain from any panic by international lenders over their solvency.

Greek unions have held general strikes in protest at austerity measures that form part of the agreement, which include widespread public sector spending cuts and reductions in wages and pensions. The Greek government is also expected to sell off airports and utility companies.

A poll at the weekend showed nearly 60% of Greeks had a negative or partly negative view of the rescue deal.

Norbert Barthle, of Merkel's Christian Democrats, said the referendum call put a big question mark around the aid package, complicating plans to get banks to accept 50% -percent losses on their Greek debt holdings.

Greece is due to receive €8bn aid in mid-November, but is likely to run out of cash again in January, around the time of the referendum. Countries such as Germany, Finland and the Netherlands may find it difficult to defend funnelling more cash to Athens over the coming months with the threat of the referendum looming.

The Dutch opposition Labour Party described Papandreou's gambit as a "deal breaker" that would doom parliamentary approval of the latest rescue measures.

However, German Eurosceptics welcomed Papandreou's announcement, saying it was time European voters were consulted on what some Berlin parliamentarians believe is a doomed policy of never-ending bailouts.

"You can't keep carrying out policies against the will of the people, it won't work," ruling Free Democrat lawmaker Frank Schaeffler told Reuters. "In Greece and in Germany we are making the mistake of not consulting the population enough in this process. I fear that the Greek people will speak out against these measures because they haven't been consulted, which will mean the collapse of this debt bailout logic."

Others described the announcement as poorly thought-out and warned that the consequences could drag down the entire 17-member currency bloc.

• This article was amended on 3 November 2011. The original said the Greek finance minister Evangelos Venizelos was rushed to hospital before the referendum announcement. In fact Venizelos went to hospital after the referendum was announced.