Italian Prime Minister Mario Monti opted on Friday not to rush a heavily contested labor reform through parliament after running into strong resistance from unions and a key ally supporting his government.

After more than five hours of discussion in cabinet, the government said it would send a regular draft bill to parliament rather than an immediately applicable emergency decree.

The move will mean that it could take several months for parliament to approve reforms that include a measure to loosen restrictions on companies firing workers and opens the door to potential changes by lawmakers.

Had the government opted for an emergency decree procedure, it could have implemented the measures immediately, fast-tracking subsequent parliamentary approval within 60 days.

The reform is being closely watched as a test of Monti's ability to push through far-reaching changes to Italy's sluggish economy and provides his first real political challenge since coming to power four months ago.

He has already passed spending cuts, tax hikes, a tough pension reform and measures to deregulate the economy without much opposition but has run into stronger resistance over the labor reforms which opponents say risk triggering a wave of layoffs.

On Wednesday, Italy's six-million strong CGIL trade union called 16 hours of strikes, including a full-day nationwide stoppage, to protest against the measures which will weaken rights won during the heyday of union power in the 1970s.

The union is particularly angered by a proposal that would reduce the obligation on companies to re-hire workers deemed by a court to have been wrongfully laid off and allow employers to offer monetary compensation instead.

The centre-left Democratic Party (PD), which is historically tied to the CGIL and one of Monti's key backers in parliament, has also vowed to amend the measure allowing single employees to be fired without the possibility of being re-hired.

"We are dealing with a government which, in the end, unloads all the real costs of what they are doing onto workers, pensioners and people soon to be on pensions," CGIL head Susanna Camusso said after calling on workers to down tools.

NO SURRENDER

President Giorgio Napolitano, who was key to putting Monti in power after Silvio Berlusconi's former government lost the confidence of international investors, said on Friday the reform was necessary and would not lead to "an avalanche of lay-offs".

Though the government indicated it was still open to compromise, it stood firm on its proposal to allow layoffs for economic reasons that has angered CGIL and the PD, although it said it would take care to "avoid abuses" of the measure.

Monti will have to walk a thin line to maintain support of his left-right coalition, whose members have staked out opposing positions on the labor reform.

In contrast to the centre-left, former Premier Silvio Berlusconi's centre-right People ofLiberty party, which is Monti's other main backer, has warned it will not tolerate backpedalling.

Employers' lobbies have also defended it even though some analysts say it is likely to boost labor costs, rather than diminish them.

A major criticism leveled at the reform plan is that by increasing the discretionary powers of judges and the courts, it will actually slow down Italy's already snail-paced procedures for deciding labor disputes.

"The real beneficiaries of this reform won't be companies or workers, but labor lawyers," Tito Boeri, a professor of economics at Milan's Bocconi University said in a TV interview.

To avoid increasing the backlog of labor disputes, the government said that a fast-track process would be set up "to reduce the indirect costs of firing".

Under the law, employers would have to pay up to 27 months' salary to a fired worker - more than is usually paid under current rules, said Michele Tamburini, a labor lawyer at Curtis, Mallet-Prevost, Colt & Mosle LLP in Milan.

"Judges and lawyers would have more work on their hands, and companies would definitely see an increase in legal costs," Tamburini said.

Though the biggest employers' group, Confindustria, backs the plan, small businesses are especially worried.

"With judges, sky-high compensation and higher labor taxes, the only ones who are going to be fired are the business owners," tweeted Filippo Berto, head of a Milanese artisans group.