His departure shocked the small Balkan nation, leaving ordinary people worried about what the future will bring, the opposition demanding early elections and analysts saying it was bad news for the country's fragile economy and credit rating.
Sanader said he was quitting politics altogether, despite speculation by some analysts it might be a tactical ploy to pave the way for a triumphant return in a presidential election early next year.
"I have decided to withdraw from active politics and not to run for the presidency," he told a news conference.
Croatian President Stjepan Mesic said he was surprised by the timing of Sanader's resignation.
"Croatia is in a serious economic situation, while the talks on EU entry are stalled. The crisis of the government does not contribute to the country's stability and will certainly draw question marks abroad," Mesic said in a statement after meeting Sanader late on Wednesday.
Sanader had served as prime minister since his conservative Croatian Democratic Union (HDZ) took power from the Social Democrats in 2003, but his second term was marred by a rapidly slowing economy and the stalling of European Union entry talks because of a border row with EU member Slovenia.
"Sanader has suffered several failures—EU talks, the economy, a poor showing at local elections," said Davor Butkovic, an editor at Jutarnji List daily. He said the HDZ stood little chance in the next election without Sanader.
Hrvoje Stojic, an analyst at Hypo Group Alpe Adria bank, said there would be "a certain political vacuum". "This is not good news for the economy, because we need swift reaction and fiscal consolidation, which is questionable in these circumstances."
The Crobex stock market index fell 4.5 percent on the news, while the kuna currency held its ground against the euro.
Raiffeisenbank said in a research note Sanader's exit would delay badly needed budget cuts, planned for mid-July, and put additional pressure on the country's credit rating.
Croatia's economy, hit by the global financial crisis, is expected to shrink some 4 percent this year, with exports falling sharply and unemployment rising steadily.
Shock Announcement
Sanader, 56, gave no reason for stepping down. "There is always a time in life for a new beginning," he said. "Such a moment has come and now it's time for others to take over."
The announcement stunned many. "This is a shock and the first reaction is definitely negative," said Ante Babic of the Centre for International Development, a think tank. "I am afraid the government will not be able to do many things. The cohesive element, the glue, is gone."
Sanader proposed his deputy Jadranka Kosor as prime minister designate. "We have already secured majority signatures in the parliament and I expect the (parliamentary) procedure to be relatively fast," he said.
The main opposition Social Democrats' leader, Zoran Milanovic, called for an early election: "We are in a difficult situation, a boat without a helmsman, without leadership."
It is now up to Mesic to mandate a new prime minister-designate. He said it will be the person who could demonstrate majority backing in parliament.
A scholar and former athlete, the smartly dressed, multilingual Sanader took over the HDZ in April 2000, succeeding the country's first president, Franjo Tudjman, who led Croatia's war of independence from Yugoslavia in the 1990s.
He transformed it from a hardline nationalist movement into a conservative party and set about steering the country towards membership of NATO—which it joined in April—and the EU.
Croatia aimed to close EU accession talks by the end of the year, but the row with Slovenia prompted Croatia's foreign minister to acknowledge last week that this would be "extremely difficult.” Sanader said he believed accession talks could be completed in three months if there was "a political decision.”
