Brown resignation - last throw of Labour's dice

On an extraordinary day at Westminster, the Prime Minister said he would stay on until a successor is appointed by the autumn as Labour last night opened formal talks with Nick Clegg's Liberal Democrats in an effort to form a coalition to keep David Cameron out of Downing Street.

His move – aimed at overcoming reluctance from Mr Clegg to do a deal with Labour which would keep the Prime Minister in Number 10 – sent shockwaves through Westminster and sent the value of the pound tumbling, just as talks between the Lib Dems and Tories over a power-sharing deal appeared to be stuttering.

It also fired the starting gun on a leadership election, although last night potential candidates including David Miliband, Ed Balls, Ed Miliband and Alan Johnson were keeping their intentions private until the conclusion of negotiations with the Lib Dems.

Mr Clegg – who finds himself cast into the role of kingmaker despite a bad election night for his party resulting in the loss of five seats – said Mr Brown's decision could be an "important element" in resolving the political impasse created by the failure of any party to win a majority last week.

Last night the Tories, who spent the weekend in positive talks with Mr Clegg's party, were forced to up their offer by pledging a referendum on changing the voting system after the Lib Dems made clear they wanted to form a coalition government with one of the other parties – but would only do so if they got backing for the alternative vote system, where voters rank candidates in order of preference.

Shadow Foreign Secretary William Hague said the offer was the Tories' "bottom line" as he warned the Lib Dems must make an "urgent" choice between the offers from Labour – which he said would not offer strong or stable government – and the Tories, who are comfortably the biggest party with 306 seats.

Mr Brown's dramatic move – sacrificing his own career in the hope it will keep Labour in power – came after the Lib Dems demanded "clarification" over education funding, fair taxes and voting reform following more talks between the two sides and concern from some MPs about a deal with the Tories.

In a telephone call to the Tory leader, Sheffield Hallam MP Mr Clegg demanded a commitment to introducing the alternative vote system, and said his party would only take part in a coalition, rather than propping up a minority Tory administration upon which negotiations had centred until this point.

Sensing a final opportunity for Labour, Mr Brown stepped in front of the cameras in Downing Street and said: "The reason that we have a hung parliament is that no single party and no single leader was able to win the full support of the country.

"As leader of my party I must accept that as a judgment on me. I therefore intend to ask the Labour Party to set in train the processes needed for its own leadership election."

Mr Clegg, who was meeting his MPs again late last night, welcomed the statement, although the pound fell sharply against the dollar after the emergence of formal talks.

Although a Tory-Lib Dem coalition would have a majority of 76, a Lib-Lab deal would also need support from other minority parties.

Offering a referendum on voting reform, Mr Hague, MP for Richmond, said: "It would be wrong to construct a government which wouldn't be stable, which wouldn't have a Prime Minister elected by the people of this country and wouldn't be submitting a major constitutional change to a referendum."