The Liberal Democrats said talks to form a new government had entered a decisive phase, after Labour PM Gordon Brown's dramatic announcement he would step aside to ease a center-left coalition.
Brown's statement late on Monday disrupted efforts by the Conservatives to broker a power-sharing deal with the Liberal Democrats after the country's first election producing no clear winner since 1974.
It is unclear which way the Liberal Democrats will turn. With markets and voters keen for an end to the political uncertainty, Liberal Democrat leader Nick Clegg said the talks had entered a “critical and final phase.”
“I am as impatient as anybody else to get on with this, to resolve matters one way or another,” he told reporters.
Conservative leader David Cameron said it was “decision time” for the Liberal Democrats, who came third in Thursday's election behind the Conservatives and Labour.
As formal talks between Labour and the LibDems resumed at the Houses of Parliament, a Labour source said: “It is a very finely balanced decision, but we are clearly back in the game.”
Britain is emerging from its worst recession since World War Two with a record budget deficit that analysts believe will only be cut effectively by a strong government.
“The market wants a conclusion to this and whilst we are without a conclusion the market will remain nervous,” said one London-based gilts trader.
The head of the French financial markets watchdog said the uncertainty was likely to hit Britain's markets, but London should not rely on EU help in any financial crisis.
“The English are very certainly going to be targeted given the political difficulties they have. Help yourself and heaven will help you,” Jean-Pierre Jouyet, who was European affairs minister from 2007-2008, told Europe 1 radio.
The Conservatives emerged as the largest party in parliament but fell 20 seats short of an outright majority, leading to a bidding war to win the support of the Liberal Democrats.
They quickly began talks with the Liberal Democrats on a government alliance. However, the smaller party wanted concessions on areas including reform of the voting system to make it more proportional.
The Conservatives responded to Brown's statement by offering the LibDems a place in a coalition and a referendum on limited electoral reform that falls short of their demand.
“That's our last offer in that area,” Conservative shadow chancellor George Osborne told the BBC. “But I'm very willing to discuss with the Liberal Democrats how we create that strong, secure government and deal with this massive economic problem.”
Sensing a hesitancy on the part of the LibDems, Brown said on Monday he would step down by the time Labour holds its annual party meeting in September.
LibDem leader Nick Clegg had said during the campaign that he was reluctant to work with Brown and the prime minister's departure could smooth the path to a deal.
Clegg, 43, finds himself in a difficult situation. His party has more in common with Labour in terms of policy, but the two parties combined would be unable to command a majority and would need to enlist the support of smaller parties in a potentially more unstable “rainbow coalition.”
An alliance with the Conservatives would offer a more stable formation, with a strong majority but a more difficult political compromise. Activists on one LibDem website were leaning towards a deal with the Conservatives, rather than Labour.
“How can anyone with any gumption call for stable government and then propose allying with a party which is going to spend the next four months in a bitter leadership contest?” said one blogger on Liberal Democrat Voice.
Britain is unfamiliar with coalition negotiations and the talks cannot drag on for weeks as they do in some of its continental European neighbors.
Parliament is due to resume sitting on May 18 and the new government will present its program on May 25. (Reuters)