"I have decided to end my functions as prime minister of the government of Israel," Olmert told a weekly cabinet meeting in Jerusalem, days after Foreign Minister Tzipi Livni was elected leader of their centrist Kadima party.
"I hope that Tzipi Livni will succeed in forming a national government with the composition she wants," Olmert said in remarks broadcast on television. "For my part I will help her with all my strength."
Olmert has been battling corruption allegations for several months, and on July 30 he said he would step down once his party chose a new leader.
But he must still submit his resignation to President Shimon Peres, who will then give Livni 42 days to form a government and avert snap general elections, which polls indicate would bring the right-wing Likud party to power.
Peres was due to travel to New York this week to attend the UN General Assembly, and it was unclear whether he would be able to set the legal process in motion before his departure by asking Livni to form a new government.
Olmert is meanwhile likely to stay on as interim premier until a new government is sworn in, which could take several months.
The Kadima leadership result confirmed Livni's meteoric rise to become the most powerful woman in Israel, and could now see her follow in the footsteps of Golda Meir, the country's first woman prime minister.
But the turmoil unleashed by the allegations dogging Olmert also threatens to derail US-backed peace talks with the Palestinians that were formally relaunched last November but have made little tangible progress since.
As foreign minister Livni has led the negotiations, which were relaunched with the stated goal of ending the decades-old conflict by the end of the year.
Both sides remain deeply divided on core issues, however, including final borders, Jewish settlements in the West Bank, the future status of Jerusalem and the fate of some 4.6 million Palestinian refugees.
The negotiations could complicate Livni's efforts to form a new coalition, with the ultra-Orthodox Shas Party -- a key partner in Olmert's administration -- having vowed to quit the government if Jerusalem is even discussed.
"No one, not even Olmert, has any political or moral authority to push any controversial decisions right now," Shas Chairman Eli Yishai said before the cabinet meeting, according to the Ynet news service.
The Palestinians want mostly Arab east Jerusalem, which Israel seized in the 1967 Six Day War, as the capital of their future state.
Israel, however, considers the entire city to be its "eternal, undivided" capital, a claim not recognised by the international community.
Meanwhile Labour party head Ehud Barak -- another key member of Olmert's coalition -- met Likud leader Benjamin Netanyahu over the weekend, with local media speculating about an emerging anti-Livni alliance.
"In view of the political, financial and security challenges we face, what Israel needs now is a national emergency government," Barak, Israel's defence minister, said ahead of the cabinet meeting, according to Ynet.
Shortly after the meeting Deputy Defence Minister Matan Vilnai, considered close to Barak, told public radio that the Labour chief would demand either a coalition including Labour, Kadima, and Likud, or early elections.
Netanyahu supports holding elections, which would probably result in his becoming prime minister, while Barak has not yet adopted a clear position on the matter.