Italian President Sergio Mattarella said he refused to approve populist leaders' choice of an economy minister who has expressed anti-euro views because the appointment would have "alarmed markets and investors, Italians and foreigners".
A technical government will still be subject to votes of confidence in both houses of parliament, and the 5-Stars and League made clear Cottarelli wouldn't have their support.
Two populist parties, the Five Star Movement (M5S) and League, agreed on a coalition deal and prime ministerial nominee, lawyer Giuseppe Conte. If Cottarelli fails, the country could face fresh elections in the fall.
Conte said President Mattarella has been in talks with former International Monetary Fund economist Carlo Cottarelli, who is tipped as a potential stop-gap prime minister.
He told reporters: "If there's not the OK of Berlin, Paris or Brussels, a government can not be formed in Italy".
President Mattarella pulled the plug on 5Star-League government after rejecting the candidacy of the Euroskeptic Paolo Savona as economy minister.
The 81-year-old billionaire former prime minister released a statement on Sunday in which he praised Mattarella's efforts to "safeguard this country's families and businesses".
The previous parliamentary election, held March 4, failed to produce a party with enough support to govern singlehandedly.
But they are gate-crashers in Italy's national politics, and on Sunday, former prime minister Matteo Renzi, a member of the Democratic Party, wrote on Facebook that Di Maio and Salvini had taken Italy hostage "for three months".
Article 90 of the Italian constitution foresees recourse to impeachment only in two cases: high treason and an attack on the constitution itself, which Di Maio has said could be invoked in the present case.
"The designation of the economy minister always constitutes an immediate message of trust or alarm" for financial markets, Mattarella said, adding that he insisted on some someone who was not "supporting a position expressed a few times that could probably, or in fact inevitably, provoke Italy's exit from the euro". He said he did best to try to give the country "a government of change".
But the stance to block eurosceptic economy minister Paolo Savona boosted sentiment towards the currency.
Both League leader Matteo Salvini and the 5-Star candidate Luigi Di Maio have criticized Mattarella's resistance to Savona, insisting it reflected the displeasure of "Berlin" and other establishment powers rather than true concern for Italians.
A government plan by the Five Star's Di Maio and Salvini of the League had spooked European Union partners and financial markets with pledges for fiscal expansion and tax cuts challenging EU budget rules. "It seems a stretch", Mr Salvini said.