Turkey's parliament voted 314-214 against Prime Minister Mesut Yilmaz's coalition. Mr Yilmaz had been expected to lose the no-confidence vote, brought by opposition parties, after he was accused of corruption in the privatisation of a state bank.
Shortly before voting commenced, the government's senior spokesman was reported to have offered a compromise in Turkey's worsening dispute with Italy by saying Ankara would accept Mr Ocalan's trial in a third country.
Tensions have been high since Mr Ocalan was arrested in Rome two weeks ago. The PKK wants autonomy for Kurds in south-eastern Turkey, but Ankara considers it a terrorist organisation and holds Mr Ocalan responsible for the deaths of 30,000 Turkish civilians.
Turkey had expected Mr Ocalan's extradition to be a formality, and was incensed when Italy said it would consider Mr Ocalan's request for political asylum.
A Rome court overturned Turkey's arrest warrant on the ground that Italian law forbids extradition in cases where the accused might face the death penalty.
Mr Yilmaz on Tuesday suggested Turkey would accept Mr Ocalan's extradition to Germany instead, as Bonn also has an arrest warrant for Mr Ocalan. But, so far, Germany has insisted it will not request the PKK chief's extradition.
In a new twist to the diplomatic crisis, it emerged yesterday that arrival in Rome of the PKK leader had been part of a plan to try to bring an end to the Kurdish rebellion. A small group of Italian left-wing MPs said they had brought him to Italy in the hope that he would launch a new peace initiative from there.
Ramon Mantovani, a member of the Refoundation party, admitted he had travelled with Mr Ocalan from Moscow to Rome. The disclosure comes as a severe embarrassment to the Italian Prime Minister, Massimo d'Alema, who insisted that Italy was "an innocent victim" in the affair.
Lawyers for the Kurdish leader are now said to be optimistic he will be granted political asylum and allowed to remain in Italy indefinitely.
In Brussels, Nato officials dismissed suggestions that they put pressure on Turkey to ease its war of words with Italy. But sources admitted there was mounting concern about the sudden deterioration of relations between the two Nato allies - and the consequences of the row for Turkey's EU membership bid.
On Tuesday, the European Commission waded in on Italy's side, threatening Turkey with retaliatory trade sanctions. Nato is worried that the new setback in the EU's shaky relations with Ankara will lead to further political isolation of a key military power that the West can ill afford to alienate.
EU heads of government, many of whom are already deeply hostile to Turkey's accession, will be presented with a damning progress report from the Commission when they meet in Vienna in two weeks. The report cites "persistent human rights violations" linked to the Kurdish question, and "major shortcomings" in the treatment of Turkey's minorities.Reuse content