"We have decided to vote for confidence, not without internal disputes," Berlusconi said before a confidence vote in Parliament on Wednesday, called after he ordered his ministers to leave the cabinet.
Berlusconi said he had changed tack after hearing Prime Minister Letta's promise to lower taxes and was mindful of the need for reforms after calling just hours before for early elections.
Letta, who had been tipped to squeak home minutes before Berlusconi's U-turn, ended up sweeping the vote with a crushing majority of 235 senators in favour and 70 against.
Letta shook his head as he listened to Berlusconi, who has dominated political life in Italy for much of the past two decades but has been on the decline.
As the 77-year-old Berlusconi left the parliament building, 100 protesters shouted "Go away!", while Letta flashed a victory sign.
The surprise about-turn was cheered by the markets, with shares in Milan jumping 1.45% although they later closed up 0.68%.
The difference between rates on Italian 10-year government bonds and benchmark German ones -- a measure of investor confidence -- also narrowed to 253 basis points from 260 points on Tuesday.
European Commission President Jose Manuel Barroso hailed the Italian Senate's vote as "decisive" not just for Italy, but for the eurozone and European Union as a whole.
"Political stability is vital for Italy and it is therefore very positive that the Italian government will be able to continue uninterrupted with the reforms it has embarked on," the head of the EU's executive arm said.
Giacomo Marramao, a politics professor at Roma Tre university, saw the day's events as the final nail in Berlusconi's political coffin.
"I think we are seeing the final chapter of Berlusconi's political life," Marramao told AFP.
Letta had earlier urged lawmakers to vote for him, saying Italians were tired of pointless wrangling.
"Italians are crying out that they cannot take any more blood in the arena, with politicians who slit each other's throats and then nothing changes," said Letta, a 47-year-old moderate leftist.
"Italy runs a risk that could be a fatal risk. Seizing this moment or not depends on us, on a yes or a no," Letta said in his address to the Senate.
Several key figures from Berlusconi's PDL broke ranks with the billionaire media mogul after his decision to call time on the government and pull his ministers from the cabinet on Saturday.
Roberto Formigoni, a PDL senator who broke ranks, told AFP: "We were not traitors but pioneers!"
"We were pioneers who showed the way forward that the PDL ended up following. We are proud of that because the government had to continue," he said.
He said he and others would break away in parliament from Berlusconi's party.
A letter doing the rounds in the Senate just before Berlusconi spoke had 23 signatures of PDL senators willing to defy their leader.
A similar document in the Chamber of Deputies, the lower house, had the signatures of 26 PDL lawmakers.
'Confidence boost for Italy'
Tensions within Italy's coalition have spiked since Italy's top court upheld a tax fraud conviction against Berlusconi in August.
These are likely to increase later this month as the Senate moves to expel the former prime minister over his conviction and bar him from the next elections.
A judge is also due to rule on whether Berlusconi should serve his one-year sentence for the fraud as house arrest or community service.
Italian President Giorgio Napolitano praised the "firm and serious" way Letta had "overcome the challenge" while warning Berlusconi against any resumption of his attacks on the government.
Christian Schulz, a senior economist at Berenberg bank, said that Letta had scored "a resounding victory, given how fragile the situation looked over the weekend. Berlusconi overplayed his hand."
"However, the fact that Berlusconi's PDL did not split for now means that the hardliners will remain in the government, which will not make it easier to agree on policies," he added.
The country is suffering the longest downturn since World War II and is struggling to meet a public deficit target of 2.9% for this year -- below the EU-mandated 3.0%.
The jobless rate has also returned to a record high of 12.2%, with youth unemployment also at its highest-ever level of 40.1%.