* Ministers to meet on housing tax on Wednesday
* Row poses new problems after Berlusconi tax fraud conviction
* Financial markets nervous of new political instability
By James Mackenzie
ROME, Aug 27 (Reuters) - Italy's fractious ruling coalition struggled on Tuesday to bridge differences over a housing tax that threatens to create a new crisis for a government already severely strained by the legal turmoil surrounding Silvio Berlusconi.
With twitchy financial markets nervous about the prospect of fresh political instability in Italy, the Milan stock market fell for a second day and government borrowing costs rose ahead of a closely anticipated bond auction on Thursday.
Ministers are due to meet on Wednesday to decide what to do about the tax on main residences, which Berlusconi's centre-right party insists must be scrapped if it is to continue supporting centre-left premier Enrico Letta.
The housing tax has dogged Letta's unwieldy coalition of traditional rivals ever since it was formed after inconclusive elections in February left no party able to govern on its own.
Senior political leaders including Letta and President Giorgio Napolitano have warned that any threat to the left-right government's survival would risk a return to the kind of turmoil seen at the height of the euro zone debt crisis, when Italy, the bloc's third biggest economy, came close to a Greek-style meltdown.
But, despite some signs of progress including proposals to replace the tax with a new local services levy, there has been no firm agreement on where to find the 4 billion euros ($5.35 billion) a year it would take to abolish the tax.
"This is a fundamental policy issue," Renato Brunetta, a Berlusconi loyalist and lower house leader of his People of Freedom (PDL) party told RAI state radio.
"The fact that the government has so far failed to present a solid proposal has created a lot of doubt, it's not serious to proceed in this way," he said.
Coming on top of mounting tensions over Berlusconi's future in parliament following his conviction for tax fraud earlier this month, the battle over the housing tax has underlined the severe constraints on Letta in trying to reverse Italy's worst postwar recession.
On Tuesday Berlusconi told PDL hardliners to stop their open threats to pull out of Letta's coalition, boosting hopes that in the end a deal will be reached to avoid an immediate crisis.
However Letta's own centre-left Democratic Party (PD) has so far rejected demands to scrap the housing tax, known as IMU, and instead proposed a partial abolition which would save most taxpayers but still hit richer Italians.
"Taking action on IMU has to be seen in a context where there are other priorities," Deputy Economy Minister Stefano Fassina told RAI radio, saying that Italy's strained public finances did not allow an across-the-board cut.
"We have limited room and various priorities. I would intervene clearly in the case of the vast majority of Italian families which pay IMU on their primary residence without going further," he said. "We need to find a point of balance."
He said scrapping the tax for 85 percent of Italians but taxing the remaining 15 percent would reduce the funding gap to 2 billion euros and allow the government to provide resources for other needs including unemployment relief.
The PDL made scrapping IMU a central plank of its campaign platform in the February election and has pressed for its abolition ever since the government was formed in April.
Reaching a deal on the housing tax has been complicated by the bitter dispute over Berlusconi's conviction and a vote within weeks in the Senate on whether to expel him from parliament and bar him from standing as an election candidate.
The PDL says it will be impossible to stay in the government if the PD keeps its vow to vote for his expulsion.
With Italy struggling to emerge from a two-year recession, the wrangling over the housing tax has blocked progress on any wider ranging reforms of an economy which has been stuck in virtual stagnation for more than a decade.