Caroline Wyatt in Berlin: His interventionist style was deeply unpopular

Mr Lafontaine, 55, the most powerful man in the German Government after Mr Schröder, has also quit his chairmanship of the Social Democratic Party (SPD).

The surprise resignation had an immediate impact on the money markets, with the Euro - for whose weakness Mr Lafontaine was blamed by many analysts - rising from $1.0880 to $1.0930 in New York.

Lafontaine and Schröder: Public solidarity, private rivalry

Speaking shortly after the resignation, Chancellor Schröder said the German Government would remain stable and that the SPD would propose a successor to Mr Lafontaine on Friday.

The decision will be made in a "friendly and united" atmosphere, he said.

BBC Berlin Correspondent Caroline Wyatt says the chancellor's authority will be bolstered by the resignation of his powerful rival.

The SPD heads the centre-left coalition which took office in October, 1998, ending 16 years of conservative ruler.

German Chancellor Gerhardt Schröder gives his reaction to Lafontaine's resignation

Mr Lafontaine wrote his resignation in a three-line letter which simply thanked the SPD's membership for their "trust and friendly co-operation".

It ended: ''I wish you successful work for freedom, justice, and solidarity. Yours, Oskar Lafontaine."

BBC Newsnight's David Sells: His resignation comes as a bombshell

No reason was given for the resignation, but newspapers reported that the chancellor had warned Mr Lafontaine during a Cabinet meeting on Wednesday that his leftist policies - particularly on taxes - were alienating voters and industry.

In stern tones, Mr Schröder accused Mr Lafontaine of making a "strategic error" in raising taxes on the energy industry during negotiations on phasing out nuclear power, Die Welt reported.

Power struggle

The cabinet outburst followed a power struggle between the chancellor and Mr Lafontaine and months of wrangling between his Social Democrats and the ecologist Greens.

Mr Schröder's centrist policies are aimed at establishing a good business climate, while Mr Lafontaine's traditional leftist politics lean more towards relieving average earners.

Mr Lafontaine took over the SPD at a low point in its political fortunes in 1995.

But he reluctantly put aside his own ambitions for the chancellery in favour of the more popular Schröder - setting the stage for a simmering rivalry that continued after the Social Democrats' election victory last fall.

Shock and surprise

The resignation may also throw the governing coalition between the Green Party and the SPD into doubt.

The BBC's Caroline Wyatt in Berlin: "It sounds like he was pushed"

Green MP Frieder Otto-Wolff said he was shocked and surprised as Mr Lafontaine had been one of the fathers of the red-green coalition.

"I think it will be very difficult indeed to continue the coalition without him," he said.

However, German opposition politicians have welcomed the resignation.

"Lafontaine's resignation is an admission that Schröder's government has failed," said Wolfgang Schaeuble, head of the main opposition Christian Democrats.

"Lafontaine's one-dimensional demand policy failed because it blew public finances, created no jobs and damaged Germany as a place to do business," said Free Democrat party leader Wolfgang Gerhardt.

Reports said his departure from the German Government would leave him free to challenge former Italian Prime Minister Romano Prodi for the coveted role of next President of the European Commission.

'Most dangerous man in Europe'

Mr Lafontaine was branded "the most dangerous man in Europe" by one British newspaper when he outraged UK eurosceptics by suggesting that the country should lose its power to decide its own tax rates.

Political Correspondent Jon Sopel: No tears shed by British ministers

The British government has reacted to the news of Mr Lafontaine's resigation by saying, publicly, that it is an internal matter for the German government.

However, BBC Political Correspondent Jon Sopel said his departure is being greeted with barely concealed delight by British ministers as he was seen as being anti-business and having old labour values.