Announcing his resignation in a televised address to the nation, 54-year-old Prachanda, who had taken the reins of the country eight months ago, accused President Ram Baran Yadav of taking an unconstitutional and undemocratic decision.
In an oblique reference to India, he said his party is ready to maintain cordial relations with the neighbouring countries but will not accept any intervention.
'I will quit the government rather than remain in power by bowing down to the foreign elements and reactionary forces,' Pushpa Kamal Dahal Prachanda said.
It is being speculated here that Communist Party of Nepal-UML, which had withdrawn support to the Maoist-led government over the issue of General Rukmangad Katawal's removal, may try to form a government with the support of Nepali Congress, the second largest party in Parliament.
CPN-UML general secretary Jhalanath Khanal and former general secretary Madhav Kumar Nepal are the two possible names doing the rounds for the post of prime minister.
Yadav has accepted the resignation of Prachanda and asked him to continue as caretaker Prime Minister until further arrangements, President's press advisor Rajendra Dahal said.
The President will formally invite all political parties on Tuesday to initiate the process of forming the next government by proving their majority.
Leaders of Nepali Congress and CPN-UML today met at the UML office and decided to form a new government by forging consensus among all the political parties. CPN-UML has called an all-party meeting tomorrow to discuss the issue.
Currently, the Maoist strength in the 601-member Constituent Assembly is 238. The NC has 112 seats, UML 108, Madhesi People's Rights Forum 53, Terai Madhes Democratic Party 21 and Sadbhavana Party nine seats. A minimum of 301 seats are required to form a government.
'I have resigned from the post of prime minister from today for the protection of democracy and peace,' Prachanda said in his address.
The announcement came after the President, who belongs to opposition NC, directed the Army Chief to continue in office, saying his dismissal by the cabinet does not meet the constitutional requirements and due process.
The Maoist regime accused Katawal of defying the government's orders by reinstating eight Generals retired by the Maoist administration.
'The move by the President is an attack on this infant democracy and the peace process..the interim constitution does not give any right to the president to act as a parallel power,' said Prachanda, whose government was reduced to a minority after key ally CPN-UML withdrawal of support.
The political crisis, which follows months of tussle between the premier and the army chief over the induction of former Maoist rebels into the army, is threatening the fragile peace process in the country that witnessed a decade-long insurgency waged by the Maoists before they returned to mainstream in 2006 after singing a peace deal.
Prachanda's government took over in August last year after the Maoists emerged as the single largest party in the Constituent Assembly elections. The Maoist leader accused national and international reactionary forces of hatching a conspiracy against his government and the nascent republic which abolished its 240-year-old monarchy in May last year.
He also accused reactionary forces of obstructing the Maoist government in its efforts to introduce various reform programmes. He admitted that the government could not perform upto the expectations of people 'due to various obstacles put by regressive forces and ongoing shutdowns and agitations.'
He said he is committed to democracy, human rights and press freedom and asserted his party's commitment to the the peace process and civilian supremacy.
The collapse of the Maoist-led government raises the spectre of renewed Maoist unrest in the country which is yet to draft a new constitution despite the formation of the Constituent Assembly in April last year.
Top Maoist leader Baburam Bhattarai said the ex-rebels can join a new government only if the President admits that he has taken an unconstitutional decision. 'Otherwise, we will go to the streets and gather the masses to fight against the anti-democratic' forces, he told an Indian TV channel.
'The so-called democratic forces specially headed by the so-called democrats in New Delhi have been dictating their patrons in Kathmandu to side with the army and fight against the democratic forces. That is why we have resigned in protest,' he said.
There are reports of demonstration by Maoists and anti-Maoist groups in parts of the country after Prachanda's resignation. The situation in Kathmandu remained calm, but security was tightened and demonstrations were banned near the Army Headquarters and the President's Office.
However, curfew has to be imposed in parts of Bhaktapur city in the east of Kathmandu as the situation turned violent after a man was hit by a bus. The angry kin of the deceased blocked roads and damaged a dozen vehicles.