Breaking with previous practice that depositors' savings were inviolable, eurozone finance ministers announced over the weekend a one-off tax on Cypriot bank accounts would be imposed as part of a €10 billion bailout by the European Union.
The measure infuriated ordinary Cypriots, who staged noisy demonstrations in the capital, Nicosia.
With hundreds of demonstrators outside the parliament chanting "They're drinking our blood", the ruling party abstained and 36 other lawmakers voted unanimously to reject the bill, bringing the Mediterranean island to the brink of financial meltdown.
The vote is considered is a stunning setback for the 17-nation currency bloc, angering European partners and raising fears the crisis could spread. Lawmakers in Greece, Portugal, Ireland, Spain and Italy have all accepted austerity measures over the last three years to secure European aid.
With an estimated 37% of the €53 billion of deposits in Cypriot banks belonging to foreigners,many of whom are Russian investors and businesses according to experts, Cypriots are not the only savers that could lose money under the deal.
Finance Minister Michael Sarris had already headed to Moscow, amid speculation Russia could offer assistance given the high level of Russian deposits in Cypriot banks. President Nicos Anastasiades, barely a month in office, spoke by phone with Russian President Vladimir Putin after the vote.
Anastasiades is due to meet party leaders this morning to explore a way forward.
EU countries had warned they would withhold €10 billion in bailout loans unless depositors in Cyprus, including small savers, shared the cost of the rescue, an unprecedented step in the stubborn debt crisis.
The European Central Bank had threatened to end emergency lending assistance for teetering Cypriot banks, which were hard hit by the financial crisis in neighbouring Greece.
Germany, facing an election this year and increasingly frustrated with the mounting cost of bailing out its southern partners, said Cyprus had no one to blame but itself for the gravity of the situation.
"Cyprus requested an aid programme," German Finance Minister Wolfgang Schäuble told ZDF television. "For an aid programme we need a calculable way for Cyprus to be able to return to the financial markets. For that, Cyprus's debts are too high."
Dutch Finance Minister Jeroen Dijsselbloem, who chairs the Eurogroup of finance ministers, said the bailout offer still stood providing the conditions were met. European Central Bank Governing Council member Ewald Nowotny called on Cyprus to show "discipline and the readiness to act rationally."
An important issue in negotiations has been the high level of deposits held in the island's banks by non-EU citizens and companies, notably from Russia, where Cyprus has established itself as a major provider of offshore financial services.