With only 153 out of 300 seats in Parliament, Papandreou said the vote would seek to confirm that he had the support of the people.
But to Greece's stunned European partners, the announcement was nothing less than political madness.
As a majority of Greeks are said to oppose Papandreou's belt-tightening, the referendum is nothing less than a vote on whether Greece should stay in the euro. The consequences for Greece and the EU itself are huge.
"It is difficult to predict what will happen to Greece if they reject it," Nobel Prize-winning economist Christopher Pissarides said.
"It will be bad enough for the European Union and the eurozone in particular, but it will be far worse for Greece.
"In the scenario of a 'No' vote Greece would declare bankruptcy immediately, they would default immediately. I can't see them staying within the euro."
The president of the World Bank, Robert Zoellick, delivered a blunt verdict: "If it passes that could be a positive signal for people. If it fails it's going to be a mess."
The uncertainty caused an immediate financial shock in Italy, driving up the heavily indebted country's borrowing costs, and wiped out confidence in French banks which had stuffed their portfolios with sovereign debt.
"The Greeks have a right to a prospect of a better future, but they must be aware that this is no longer a purely internal Greek problem," Belgian Prime Minister Yves Leterme warned.
Confidence has also ebbed in the EU's decision-making machinery. Buoyed by its bold decisions in Brussels last week, the EU had been courting China to back a planned €1 trillion currency support fund.
The revival of the crisis now casts a shadow over the G20 summit. French President Nicolas Sarkozy, who hosts the meeting, had been hoping it would forge a strategic view of the world's economy, setting down new co-ordination on tax fraud, financial reforms and currency disputes.
Instead, it could become an exercise in firefighting and fudge - of desperate confabs in hallways and backrooms, masked by official communiques larded with calming prose.
In a report that eerily coincided with Papandreou's announcement, the Organisation for Economic Co-operation and Development (OECD) warned that the prospects for Cannes would be clouded by any inaction by the EU to implement its big rescue plan.
"Much of the current weakness is due to a generalised loss of confidence in the ability of policymakers to put in place appropriate responses," OECD chief Angel Gurria said.
"It is therefore imperative to act decisively to restore confidence and to implement appropriate policies to restore longer-term fiscal sustainability."
This view is finding an echo across Europe. With the stakes so high and the need to ring-fence the Greek crisis, Paolo Subacchi of the London-based think tank Chatham House also says the leaders owe it to the public to provide that confidence.
WHAT HAPPENS NOW
1 The Greek Cabinet has backed George Papandreou's plan for a referendum on austerity measures. But his Government still faces a vote of confidence, set for Saturday.
2 Papandreou was summoned to emergency talks this morning on implementation of the bailout convened by France's Nicolas Sarkozy and Germany's Angela Merkel in Cannes, France.
3 The Group of 20 Summit begins tonight in the French Riviera.
4 A Government spokesman said the referendum would be held "as soon as possible".
5 The broader eurozone deal could collapse. The Greek Government could collapse with only a two-seat majority. Ultimately Athens could be left to go bankrupt if it went through with the vote. It could leave the euro union, pushing the global economy back into recession.
- AP
