* Deal would change Italy's electoral system, font of instability
* Berlusconi has kept relatively low profile since Senate expulsion
* An agreement would need parliamentary approval process
ROME, Jan 19 (Reuters) - Silvio Berlusconi has returned to the political scene after a tax fraud conviction, striking a deal with the leader of the largest centre-left party on electoral reform that could give Italy badly needed stability.
But the Saturday night agreement between 77-year-old Berlusconi, still head of the centre-right Forza Italia party he founded, and Democratic Party (PD) leader Matteo Renzi has divided the governing coalition.
Smaller parties in the coalition of Prime Minister Enrico Letta, who also belongs to the PD, are irate about such an agreement because they could risk extinction under a new electoral system.
The left wing of the PD has accused Renzi, 39, of facilitating the rehabilitation of a convicted criminal. Berlusconi denies the fraud charges and is appealing a separate conviction for paying for sex with an underage girl.
With the highest debt burden in the euro zone after Greece, Italy - mired in its longest post-war recession - is closely watched by financial markets and European partners as a flashpoint for instability in the bloc.
Italy's politicians are making a fresh attempt to reform the electoral system in the hope of providing steadier and more durable government.
In last year's election, no party gained enough votes to govern alone, plunging the country into political stalemate before the creation of a broad-based coalition government which has constantly bickered and struggled to produce reforms.
Renzi, who is also mayor of Florence, held two-and-a-half hours of talks with Berlusconi at PD headquarters in Rome.
The irony of Berlusconi entering the headquarters of the political heirs of the communist party he has long despised, was not lost on anyone. The offices still have pictures of Fidel Castro and Che Guevara on their walls.
A demonstrator hit Berlusconi's car with an egg and another held up a photo montage of the former prime minister behind bars. He was expelled from parliament in November after the fraud conviction became definitive and has been leading his party from outside parliament.
Renzi and Berlusconi favour a system based on proportional representation with a large number of small constituencies each electing four or five representatives and a winner's bonus of 15-20 percent of seats. Parties winning below five percent of the vote would not get into parliament.
After the meeting Renzi said he and Berlusconi were "in tune", agreeing on the need for an electoral law that "favours governability and a bi-polar system, and eliminates the blackmail power of the smallest parties".
Berlusconi said the accord would "consolidate the largest parties and simplify the political system".
Letta, whose relations with Renzi have sometimes been tense, said the accord was "going in the right direction" towards electoral reform, which would involve a lengthy process of parliamentary approval and constitutional amendments.
Both Berlusconi and Renzi also favour a reform of the upper house Senate so that it does not merely duplicate the work of the lower house Chamber of Deputies as well as changes to the governing structure of Italy's regions and provinces.
Small parties backing Letta's coalition - including the New Centre Right (NCD) of Deputy Prime Minister Angelino Alfano and the Civic Choice of ex-premier Mario Monti - have threatened to bring down his administration unless they have a say.
Alfano, who broke with Berlusconi to form the NCD last year, said on Sunday that a reform of the electoral law would be "impossible without us" and added: "We want coalitions and not just two parties, which goes counter to Italian history."
Electoral reform rocketed to the top of the political agenda last month when the constitutional court called part of the current electoral law "manifestly unreasonable".
It struck down the system of voting for party lists of candidates and the rules that gave the largest coalition an automatic 55 percent of seats - on a national basis in the lower house and regionally in the senate. It also said voters should have the right to choose representatives, not simply vote for lists picked and ranked by party bosses.