* Letta wins Senate confidence vote by 235 votes to 70
* Also wins comfortably in lower house of parliament
* Centre-right in disarray after shock Berlusconi turnaround
* Financial markets rise as government survives
By Paolo Biondi
ROME, Oct 2 (Reuters) - Italian Prime Minister Enrico Letta won a confidence vote in parliament on Wednesday after Silvio Berlusconi, facing revolt in his own centre-right party, backtracked on threats to bring down the government.
As dozens of centre-right senators prepared to defy their media magnate leader and salvage the left-right coalition led by Letta, Berlusconi staged an abrupt U-turn and said he too would back the centre-left prime minister, just days after he sparked the crisis by pulling his ministers out of Letta's cabinet.
After a sometimes fiery debate in the upper house, in which he faced repeated accusations of sowing chaos in a personal bid to stave off expulsion from parliament over a tax fraud conviction, Berlusconi said: "We have decided, not without some internal strife, to support the government."
Financial markets reacted positively. But the end of this crisis, seven months after an inconclusive election, leaves question marks over Letta's ability to address deep problems in Italy's economy which are troubling its partners in the euro.
Letta, who had appeared on course for victory with PDL help even before the startling turn of events in the chamber, reacted with visible surprise to Berlusconi's climbdown, laughing slightly and shaking his head in disbelief.
Berlusconi covered his face with his hands after he sat down; in what may be one of his last acts in the Senate before the procedure for his removal begins on Friday, the 77-year-old then cast his vote for Letta, a prime minister whom he had accused a day earlier of lacking credibility.
Later, as he drove away, he was heckled by onlookers.
"What happened today should be shown in a theatre not in parliament," Federico D'Inca, a deputy from the opposition 5-Star Movement said during a debate in the lower house, where Letta won a second confidence vote in the evening.
Backed by his own Democratic Party (PD) and by Berlusconi's People of Freedom (PDL), the prime minister won the Senate vote by 235 to 70. He then won by 435 to 162 in the lower chamber, where the PD holds a strong majority.
President Giorgio Napolitano, an 88-year-old veteran who has delayed his own retirement to try and broker a viable compromise that can steer Italy out of crisis, praised Letta's "firmness" in parliament. "The main thing is the government has stood the test," he said in a statement. But he warned it against allowing a return to a daily round of aggressive political rhetoric.
Appointed in April after an election in February that gave no one a clear majority, Letta said he would press on with a programme of fiscal measures to keep Italy's badly strained public finances under control and reforms to confront the worst recession in 60 years.
He also pledged to reform the widely criticised electoral law which gives the two houses of parliament equal powers and makes it difficult for any party to win a functioning majority.
However, the surprising nature of his victory leaves a series of unanswered questions about both the stability of his government and the future of Italy's centre-right, which came close to implosion as the vote neared.
Having begun as a vote of confidence in Letta, the day turned into a test for Berlusconi, whose previously unchallenged grip on the conservative side of the political spectrum faced its biggest threat since he took up politics two decades ago.
His declaration for the prime minister capped a day that veered between high drama and what one centrist politician called farce, as an unprecedented party rebellion persuaded Berlusconi that there was no point in continuing resistance.
"Berlusconi lost, regardless of the fact that he voted for the government," PD party secretary Guglielmo Epifani said. "He lost above all before the country and Italian public opinion."
Where the climbdown leaves his badly divided party will become clearer in the next few days. Dissidents are already making clear they want to set up a separate moderate group away from the hardliners, who have gained an increasing influence over Berlusconi since his conviction.
Angelino Alfano, the 42-year-old PDL party secretary who was once seen as Berlusconi's heir, broke with his patron and called on the party to support the Letta government from which he himself had resigned as interior minister on Saturday.
An opinion poll by the Ipsos institute conducted on Tuesday showed 61 percent of PDL voters felt the party should back Letta and 51 percent that it should pick a new leader to take over from Berlusconi and renew the party.
Financial markets, already buoyed by confidence that Italy would avoid uncertain new elections, welcomed the vote. Shares on the Milan bourse rose nearly two percent and yields on 10-year government bonds fell to a low for the day of 4.34 percent.
As the debate on the confidence motion opened, Letta said Italy risked being left without a stable government.
"Italy is running a risk that could be fatal, without remedy," he told the Senate. "Thwarting this risk, to seize or not seize the moment, depends on the choices we will make in this chamber. It depends on a yes, or a no."
However, uncertainty remains over whether the government will be capable of the kind of deep reforms or painful tax and budget measures needed to reverse a decade of economic stagnation and cut its 2 trillion euro ($2.7 trillion) debt.