The cave-in was announced in a brief statement from the Elysée Palace after two months of protests brought millions onto the streets of France.

"The President of the Republic has decided to replace Article 8 of the law on equal opportunities with measures in favour of the professional insertion of young people in difficulty," it said.

The decision is a major blow to the credibility of M Chirac and his protégé Dominique de Villepin, the Prime Minister who had been groomed to replace M Chirac in next year's presidential elections.

It was M de Villepin who championed the First Employment Contract (CPE) as an attempt to bring down youth unemployment from an average of over 22 per cent. The law would have allowed employers to fire workers under the age of 26 without giving a reason during their first two years of employment. It provoked the most serious mass protests France has seen since the student strikes of May 1968.

In a televised address, a sombre M de Villepin said: "The necessary conditions of trust and serenity were not present, either among young people or businesses, to allow the implementation of the First Employment Contract."

The Prime Minister explained that his original legislation - introduced after a frenzy of rioting in immigrant estates around Paris and other cities late last year - had been designed to curb the "despair of many youths" while striking a better balance between flexibility for employers and security for workers.

"This was not understood by everyone, I'm sorry to say," he said.

M Chirac signed the CPE into law earlier this month, but had already announced that it would be immediately suspended while conservative deputies tried to find a way out of the crisis.

Unions and student groups, which had been demanding the measure’s complete withdrawal, were to meet later today decide what further action to take, although some student leaders suggested that the battle was now over.

Bruno Juillard, a key student leader, hailed M Chirac’s announcement as "a decisive victory", but urged the protestors to keep up the pressure until Parliament votes on a new law superceding the CPE.

Another student leader, Julie Coudry, called immediately for protesters to lift the blockades that have paralysed dozens of French universities so that students could prepare for end-of-year examinations. "The CPE is dead, the CPE is well and truly finished," she said.

"If there is a new text in which the CPE does not appear, that will mean it has been withdrawn. That is what counts," added Francois Chereque, head of the CFDT union.