Euro zone finance ministers promised cheaper loans, longer maturities and a more flexible rescue fund to help Greece and other EU debtors in a bid to stop financial contagion engulfing Italy and Spain.

They also declined to rule out the possibility of a selective default by Greece to make its debt mountain more sustainable, despite the European Central Bank's fierce opposition, one participant said.

After talks on Monday following another day of turmoil on financial markets, ministers from the 17 countries that share the European currency vowed to safeguard stability in the euro area and promised new measures shortly, but set no deadline.

Ministers stand ready to adopt further measures that will improve the euro area's systemic capacity to resist contagion risk, including enhancing the flexibility and the scope of the EFSF, lengthening the maturities of the loans and lowering the interest rates, including through a collateral arrangement where appropriate, they said in a statement.

Italian and Spanish stocks and bonds suffered another big selloff on Monday and the euro fell as investors rattled about an apparent deadlock in the EU on how to involve private bondholders in a second rescue package for Greece.

The euro fell further after IMF Managing Director Christine Lagarde said the lender and its European partners were not yet ready to discuss terms for a second Greek bailout.

Nothing should be taken for granted, she told reporters in Washington.

The Italian slide was triggered last week by concerns that Prime Minister Silvio Berlusconi was trying to undermine and perhaps remove Finance Minister Giulio Tremonti, seen as the guarantor of fiscal prudence in Rome.

Italy, the third-largest economy in the euro zone, has the second-biggest per-capita debt after Greece but has avoided the fate of Greece, Ireland and Portugal, forced to seek EU/IMF bailouts, because it has a low budget deficit and a liquid bond market largely in domestic hands.

The ministers gave no indication that they had broken a stalemate over how to make banks, insurers and other funds share the cost of additional funding for Athens.

But one national official said they were moving closer to sharing the cost of easing Greece's debt burden with investors even if credit ratings agencies were to declare a selective default.

I would read this as an acknowledgement by the member states that a selective default is going to be difficult to avoid. It removes an obstacle to the participation of the private sector, the official said, speaking on condition of anonymity.

Ministers tasked a working group to propose ways to finance a new multi-year program for Greece, reduce the cost of servicing its 340 billion euro debt -- nearly 160 percent of annual output -- and improving its sustainability.

WITHERING LETTER

Jean-Claude Juncker, chairman of the Eurogroup of finance ministers, told a news conference there would clearly be private-sector involvement in the new bailout and talks on how to do this would be concluded as soon as possible.

If the weight of Greek public debt is corrected downwards, if the interest rates are lowered and if the maturities are lengthened, then you might well get the impression that this will be of great help to Greece, he said.

In a withering open letter to Juncker, Greek Prime Minister George Papandreou said European partners had acted too slowly to stem the crisis and put domestic politics before the common currency.

Crunch time has arrived and there is no room for indecisiveness and errors such as taking decisions that in the end prove 'too little, too late' to convince the markets we are serious; (and) making compromises that satisfy our internal political 'red lines' that in the end substitute tactical politics for sound management of the crisis, he wrote.

The EU was allowing a cacophony of voices and views to substitute for a shared agenda, thereby creating more panic than security, Papandreou added.

Although their statement did not specifically mention the option, ministers are considering buying back Greek debt or the private sector swapping holdings for longer-dated maturities in a move to make Greece's debt more sustainable.

Papandreou rejected a French alternative for private-sector creditors to roll over around 70 percent of their Greek debt into 30-year bonds and other AAA-rated securities as too costly for Greece as too expensive, too little and too dangerous.

Germany, the Netherlands, Austria and Finland are determined that private bondholders should bear a chunk of the costs of a second bailout, expected to total 110 billion euros.

As the French plan has faltered, Berlin has revived a proposal to swap Greek bonds for longer-dated debt that would extend maturities by seven years.

However, the ministers noted that the European Cental Bank had reaffirmed that any solution must avoid a credit event or a selective default.

Both a buyback and a bond swap would likely be regarded by ratings agencies as a default, or at best a selective default, which could have profound repercussions for global financial markets.

Euro group sources said ministers were likely to meet again before the end of July to try to clinch an agreement.

We do pursue a voluntary basis but it has to be substantial private-sector involvement. That's our commitment and also our parliament that demands it, Dutch Finance Minister Jan Kees De Jager said.

In a buy-back, the bloc's European Financial Stability Facility (EFSF) bailout fund might buy Greek bonds from the market, or lend Greece money to do so. Officials say that would require changes to EFSF's rules which would need the backing of national parliaments -- a further potential obstacle.

ITALY FOCUSING MINDS

Policymakers have been seized with a new sense of urgency after Italy came under market attack last week, fearing any further delay in putting together a second Greek package could poison investor confidence in weak economies around the region.

After talking by phone to Berlusconi, German Chancellor Angela Merkel said Rome needed to demonstrate it was undertaking the budget reforms needed to restore confidence and she was confident that it would do so.

Italy also needed to boost economic growth to help restore confidence, Lagarde said, adding the IMF had to be alert to any significant difficulties arising from the effects of contagion.

Earlier, Herman Van Rompuy, the president of the European Council, met ECB President Jean-Claude Trichet and Jean-Claude Juncker, the chairman of the Eurogroup, for talks in Brussels ahead of the euro zone finance ministers' gathering.

Van Rompuy's spokesman described the meeting, which European Commission President Jose Manuel Barroso and EU economic and monetary affairs commissioner Olli Rehn also attended, as a coordination, not a crisis meeting.

He said Italy was not on the agenda but senior EU sources said it would be impossible not to discuss it following a large sell-off in bonds and stocks that the Italian media have dubbed black Friday.

The cost of insuring Italian debt against default jumped to a record high on Monday, the 10-year yield spread over German debt widened to a euro-era high of 300 basis points and bond yields rose above the 5.7 percent area which bankers say will start putting heavy pressure on Italy's finances.

The sell-off has increased fears that Italy could be next to get dragged into crisis. If that came to pass, the euro zone's existing rescue mechanism, the EFSF, would have insufficient funds to help. (Additional reporting by John O'Donnell, Leigh Thomas and Luke Baker in Brussels, Silvia Westall in Vienna, Stephen Brown in Berlin, Lesley Wroughton in Washington and Milan/Rome bureaus, writing/editing by Paul Taylor)