Brown sets timetable for his departure – and puts Labour back in the game

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Gordon Brown paved the way for a possible coalition between Labour and the Liberal Democrats by announcing his resignation yesterday in an attempt to derail a partnership deal between Nick Clegg and David Cameron.

Mr Brown stunned the political world by saying he would stand down as Labour leader by September but will remain Prime Minister until then if he can negotiate a deal with the Liberal Democrats. But the bidding war between Labour and the Conservatives for Liberal Democrat backing and the keys to No 10 took another twist late in the day when the Tories made a more generous and "final" offer to Mr Clegg – a referendum on replacing the first-past-the-post system with the alternative vote (AV), in which people list candidates in order of preference. Labour has already offered immediate legislation on this and a possible referendum on a proportional system later.

For their part Liberal Democrat MPs held a meeting in the House of Commons last night, after which a senior source said further talks on which way the party would side will resume today.

On the most tumultuous day at Westminster since the fall of Margaret Thatcher, it had appeared that the Tories and Liberal Democrats were edging towards a coalition deal that would have put Mr Cameron in No 10, possibly as early as today.

The extent to which the Tories and Lib Dems had converged during negotiations was revealed by shadow Education Secretary Michael Gove on Newsnight. Mr Gove suggested that his party had "moved towards" the Lib Dem proposal to make the first £10,000 of earnings tax-free, while Mr Clegg's party had come round to the Conservative argument that the budget deficit must be dealt with more quickly. Mr Gove added that the Tories had offered cabinet positions to the Lib Dems. But despite apparently finding common ground, Mr Clegg failed to win enough concessions on electoral reform to satisfy his 57 MPs, who called for formal talks with Labour to begin after informal soundings over the weekend.

That opened the door for Mr Brown to make his extraordinary announcement. He told aides he had decided to stand down last Friday, the day after losing the election, saying he was not the right man to lead Labour into the next one. Although he told Mr Clegg of his intention at the weekend, he was widely seen among Liberal Democrats as the roadblock to a Lib-Lab deal.

His statement, which triggers a Labour leadership election, was hailed as a "game-changer" by ministers but infuriated Tories. They warned that Britain could end up with a Labour premier who had not been elected by voters or taken part in the televised leaders' debates. They condemned the "rainbow coalition" proposed by Labour as "a coalition of losers".

The Labour move is all the more remarkable because, in the 20th century, the lead partner in a coalition or partnership agreement was the party which won the most seats. Labour won 258 seats last week to the Tories' 305.

Labour and the Liberal Democrats would not have enough seats together to command an overall Commons majority of 326 – unlike the Lib Dems and the Tories. So the "progressive alliance" proposed by Mr Brown would need to include some MPs from minority parties such as the Scottish National Party, Plaid Cymru, the Democratic Unionist Party and the single Green Party MP. As formal talks between Labour and the Lib Dems opened last night, it was unclear whether Mr Brown's gamble would pay off.

Some Liberal Democrats still see a deal with the Tories as a more realistic prospect, not least because of the parliamentary arithmetic. A formal Lib-Con coalition, with Liberal Democrats sitting in a Cameron Cabinet, is now seen as the most likely method of co-operating if there is such a deal, rather than a commitment by Mr Clegg's party to support a Tory minority government in key Commons votes. So Mr Cameron, while upstaged by Mr Brown yesterday, could yet be installed in No 10 by the end of the week.

Many Labour MPs, and some Liberal Democrats, believe their two parties are more natural bedfellows for Mr Clegg's party than the Tories. Some Tories fear a Lib-Lab deal could lead to a proportional voting system that would keep them out of power for ever. The secret talks exploded into the public domain after Mr Brown said he would quit as Labour leader. The Cabinet rallied behind him, even though some were said to be shell-shocked and to have private reservations about the plan to cling on to power.

Labour's attempt to put on a united front was scuppered when John Reid, the former home secretary, condemned the rainbow coalition as a recipe for instability and "mutually assured destruction". He said: "The idea that you can form a pact that will perhaps include the [Scottish nationalists] and the DUP in Northern Ireland, whose only demand will be that all of the cuts will fall in England and not Ireland or Scotland, seems to me just crazy."

Several Labour MPs said the party should accept it had lost the election, and regroup in opposition.

William Hague, the shadow Foreign Secretary, warned it would be a "great mistake" for the Liberal Democrats to link up with Labour given their "apparent attachment to improving democracy". "It would be wrong to construct a government, which would not be stable, which would not have a Prime Minister elected by the people ... and would not be submitting a major constitutional change to a referendum of the country," he added.

A senior Tory source said: "On voting reform we have now reached our bottom line and we believe that the Prime Minister of the country should be an elected leader and that a major constitutional change should be put to a referendum.

"So whatever they now decide, we will stand our ground. If they go the other way we will be in full opposition."