The Japanese Parliament today rejected plans to privatise the country's postal system, prompting Prime Minister Junichiro Koizumi to ask his cabinet to dissolve Parliament and call a snap general election.

Privatising the post office, one of Japan's biggest institutions and the world's largest savings bank, is at the heart of Mr Koizumi's plan to reshape Japanese government as a whole. It has become synonymous with his attempt to lead the most radical reform of public spending since the Second World War.

Heizo Takenaka, the Economy Minister who drew up the proposal, said that today's 'no' vote by the upper house of the Japanese parliament was a damaging setback to the overall reform agenda.

"These were the bills that put us at the crossroads, whether Japan can create a small government or it is headed toward creating a big government," he said. "The rejection is a major blow to Japan’s future and its economy."

Today's vote was the culmination of strong resistance to the privatisation by opposition parties and also by members of Mr Koizumi's own Liberal Democratic Party (LDP), who complained that the measure would cut postal services to rural areas and lead to massive redundancies.

Last month, the bill passed through the lower house of Parliament by only five votes after 37 members of the LDP rebelled against the Prime Minister and 14 abstained.

Today, the upper house rejected the proposal by 125 votes to 108. Mr Koizumi had promised to call a general election if the legislation failed.

Calling for a dissolution of the lower house of Parliament to make way for a general election on September 11, the Prime Minister said that he would maintain his reform agenda and purge his party of those who had defied him.

Recalling his election slogan of four years ago, when he threatened to split the LDP, which has governed Japan for much of the last 50 years, in two if necessary, Mr Koizumi said: "I will smash the old LDP and forge ahead with a new LDP."

Mr Koizumi's Cabinet Secretary, Hiroyuki Hosoda, said it was time to present reform to the people of Japan. "Koizumi’s efforts have been toward reforming Japan. If this point can’t be understood among lawmakers, there’s no choice left but to seek judgment from the people," Mr Hosoda told reporters.

Critics of the Prime Minister and his proposals say today's vote proves that his ambitious attempt to reform public spending is misguided. Some analysts predict that Mr Koizumi will split his party and lose the September election to the Democratic Party, which opposed the privatisation.

Tatsuo Kawabata, secretary-general of the Democratic party, criticised Mr Koizumi for staking his Government on the legislation and forcing Parliament to consider his proposals under such pressure.

"It is extremely abnormal to tell lawmakers to vote for the bills or Parliament will be dissolved," he said, adding that his party was confident of success in a general election. "We have been campaigning for change of government so it will be good for us if we can test public mandate."

Japan Post would have become one of the world's largest banks if privatisation had gone ahead. It has 350 trillion yen (£1.75 trillion) in savings under management, as well as 24,700 offices and nearly 400,000 employees.

In the past, the post office has bought government bonds to fund popular but extravagant public works projects. In return, local post office leaders have retained enormous influence over politicians. Mr Koizumi sought to break those links, inviting enormous controversy and powerful feelings which led to the suicide of one MP last week.

The legislation rejected today proposed privatising the post office by 2017 and splitting the institution into private companies handling mail delivery, banking and insurance. Proponents of the plan said the huge release of private capital would help jump start Japan's stagnant economy.

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