* Beppe Grillo's 5-Star Movement stuns Italy
* Centre-left coalition wins lower house but fails to control Senate
* Financial markets react negatively as government paralysis feared
* European governments express concern
By James Mackenzie and Naomi O'Leary
ROME, Feb 26 (Reuters) - Italy's stunned political parties searched for a way forward on Tuesday after an inconclusive election gave none of them a parliamentary majority and threatened prolonged instability and a renewal of the European financial crisis.
The results, notably the dramatic surge of the anti-establishment 5-Star Movement of comic Beppe Grillo, left the centre-left bloc with a majority in the lower house but without the numbers to control the upper chamber, the Senate.
Financial markets fell sharply at the prospect of a stalemate that reawakened memories of the crisis that pushed Italy's borrowing costs toward unsustainably high levels and brought the euro zone to the brink of collapse in 2011.
"The winner is: Ingovernability," ran the headline in Rome newspaper Il Messaggero, reflecting the deadlock the country will have to confront in the next few weeks as sworn enemies are forced to work together to form a government.
Ratings agency Standard & Poor's said on Tuesday that policy choices of the next Italian government would be crucial for the country's creditworthiness, underlining the need for a coalition that can agree on new reforms.
Pier Luigi Bersani, head of the centre-left Democratic Party (PD), has the difficult task of trying to agree a "grand coalition" with former prime minister Silvio Berlusconi, the man he blames for ruining Italy, or striking a deal with Grillo, a completely unknown quantity in conventional politics.
The alternative is new elections either immediately or within a few months, although both Berlusconi and Bersani have indicated that they want to avoid a return to the polls if possible: "Italy cannot be ungoverned and we have to reflect," Berlusconi said in an interview on his own television station.
For his part, Grillo, whose movement won the most votes of any single party, has indicated that he believes the next government will last no more than six months.
"They won't be able to govern," he told reporters on Tuesday. "Whether I'm there or not, they won't be able govern."
He said he would work with anyone who supported his policy proposals, which range from anti-corruption measures to green-tinted energy measures but rejected suggestions of entering a formal coalition: "It's not time to talk of alliances... the system has already fallen," he said.
The election, a massive rejection of the austerity policies applied by Prime Minister Mario Monti with the backing of international leaders from U.S. President Barack Obama to German Chancellor Angela Merkel, caused consternation across Europe.
German Finance Minister Wolfgang Schaeuble put a brave face on it, saying "that's democracy".
Spanish Foreign Minister Jose Manuel Garcia-Margallo was more pessimistic.
"This is a jump to nowhere that does not bode well either for Italy or Europe," he said.
A long recession and growing disillusionment with mainstream parties and tax-raising austerity fed a bitter public mood and contributed to the massive rejection of Monti, whose centrist coalition was relegated to the sidelines.
Projections by the Italian Centre for Electoral Studies showed that the centre-left will have 121 seats in the Senate, against 117 for the centre-right alliance of Berlusconi's PDL and the regionalist Northern League. Grillo would take 54.
That leaves no party with the majority in a chamber which a government must control to pass legislation.
"THE BELL IS RINGING"
On a visit to Germany, President Giorgio Napolitano said he would not comment until the parties had consulted with each other and Bersani called on Berlusconi and Grillo to "assume their responsibilities" to ensure Italy could have a government.
He warned that the election showed austerity policies alone were no answer to the economic crisis and said the result carried implications beyond Italy.
"The bell is ringing for Europe as well," he said in his first public comments since the election.
He said he would present a limited number of reform proposals to parliament, focusing on jobs, institutional reform and European policy.
However forming an alliance may be long and difficult and could test the sometimes fragile internal unity of the mainstream parties.
"The idea of a majority without Grillo is unthinkable. I don't know if anyone in the PD is considering it but I'm against it," said Matteo Orfini, a member of Bersani's PD secretariat.
"The idea of a PD-PDL government, even if it's backed by Monti, doesn't make any sense," he said.
For his part, Berlusconi won a boost when his Northern League ally Roberto Maroni won the election to become regional president of Lombardy, Italy's economic heartland and one of the richest and most productive areas of Europe.
For Italian business, with an illustrious history of export success, the election result brought dismay that there would be no quick change to what they see as a regulatory sclerosis that has kept the economy virtually stagnant for a decade.
"This is probably the worst possible scenario," said Francesco Divella, whose family began selling pasta under its eponymous brand in 1890 in the southern region of Puglia.
Berlusconi's campaign, mixing sweeping tax cut pledges with relentless attacks on Monti and Merkel, echoed many of the themes pushed by Grillo and underlined the increasingly angry mood of the Italian electorate.
But even if the next government turns away from the tax hikes and spending cuts brought in by Monti, it will struggle to revive an economy that has scarcely grown in two decades.
Monti was widely credited with tightening Italy's public finances and restoring its international credibility after the scandal-plagued Berlusconi, who is currently on trial for having sex with an under-age prostitute.
However, Monti struggled to pass the kind of structural reforms needed to improve competitiveness and lay the foundations for a return to economic growth. A weak centre-left government may not find it any easier.
The view from some voters, weary of the mainstream parties, was unrepentant: "It's good," said Roger Manica, 28, a security guard in Rome, who voted for the centre-left PD.
"Next time I'll vote 5-Star. I like that they are changing things, even if it means uncertainty. Uncertainty doesn't matter to me, for me what's important is a good person who gets things done," he said. "Look how well they've done."
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The former European commissioner, Monti was called in by the Italian President Giorgio Napolitano to take over for Silvio Berlusconi in November 2011, at the height of the financial storm that struck the European Union. Monti's government was given an enthusiastic welcome by the markets, and enjoyed the support of a broad coalition: from the Democratic Party to Silvio Berlusconi's The People of Freedom party. Over a 13-month tenure in Palazzo Chigi, Monti enacted a major overhaul of Italy's pension system, reformed the labor market and made significant cuts in government spending. But his most radical reforms were blocked in parliament by vetoes from different parties, and in the end his government managed to accomplish far less than it initially promised.
Currently running for a sixth time, Berlusconi has previously earned three victories (1994, 2001 and 2008) and suffered two defeats (1996 and 2006). He leads the center-right coalition, allied with the Northern League and the conservative party, The Right. However, for the first time in his political career, il Cavaliere will not run as a candidate for prime minister, and officially the parties have not yet reached an agreement on who they'll choose as prime minister in the event of a victory. Berlusconi wants to install his heir apparent, Angelino Alfano. The Northern League wants to see ex-finance minister Giulio Tremonti given the position.
Pier Luigi Bersani
Secretary of the Democratic Party since 2009, Bersani defeated his challenger Matteo Renzi in the primaries. Renzi is the young mayor of Florence, and ran on a platform pushing for major reforms within the party. Bersani has formed an alliance with former communist Nichi Vendola, but has often declared his willingness to expand the coalition following the vote to include Monti's centrists. Everything will depend on the outcomes of voting in several key regions. If the center-left fails to win a majority in the senate, a deal with the outgoing prime minister will become inevitable.
The surprise of this electoral campaign. Grillo is the only political leader who hasn't given any interviews, and who chose not to appear on any TV show. He has run his electoral campaign entirely via Internet and in public piazzas, traveling all over the country and drawing huge crowds wherever he has appeared. He is also the only political leader who is not a candidate for parliament, despite the fact that his party appears destined to earn more than 20 percent of the vote. No matter what the outcome of the elections is, Grillo has already declared that he will not make an alliance with anyone, and that his Five Star Movement will always remain in the opposition.
Last year, Giannino, journalist and economist, founded the movement Stop the Decline, a party with liberal aspirations that considers both Berlusconi's center-right and Mario Monti's center-left to be adversaries. Giannino supports progressive government withdrawal from the economy, and is calling for a major reduction in fiscal pressure (Italy's is currently among the highest in Europe). After an early, rapid rise in the polls and now just a couple of weeks from election day, Giannino became embroiled in a minor "scandal" when one of his main supporters publicly accused him of having lied about a masters degree he claims to have earned from the University of Chicago. Despite subsequent clarification, the episode significantly weakened the party, and will in all likelihood prevent him from entering parliament.
A magistrate from Palermo who grappled with the mafia, Ingroia decided to temporarily abandon his profession in order to lead the center-left political coalition Rivoluzione Civile (Civil Revolution). While his party may win some seats in the House, it will be very difficult for him to win any seats in the Senate (except in a few individual regions). Among the main themes of its program, Rivoluzione Civile promises to wage a fierce war on corruption and organized crime. Ingroia is also calling for a revision of the Fiscal Compact, the accord underwritten in 2011 by Berlusconi that forces all European member states to enact tough measures designed to reduce government spending.