The Premier, Morris Iemma, is also under pressure from ministers and MPs to dump his Treasurer, Michael Costa, after the failed electricity privatisation bid. A senior cabinet source said Mr Costa walked out of a cabinet meeting on Tuesday when the electricity issue came up and ministers are understood to have told the Premier that they do not have faith in Mr Costa delivering the mini-budget in November and that he should be axed.

The deputy premier's retirement will force Mr Iemma into a long-awaited reshuffle of his cabinet, providing the Premier with one final chance to revive his beleagured Government or face a certain leadership challenge.

Yesterday Mr Iemma would not guarantee the future of Mr Costa. When pressed on the matter, Mr Iemma said: "What I'm not doing is getting into a running commentary. There's a reshuffle on, I will be announcing that on Friday."

It is believed that if Mr Iemma does not replace Mr Costa as Treasurer it could provide the impetus for the Minister for Water, Nathan Rees, to challenge Mr Iemma for the leadership.

The head office of the NSW Labor Party has touted Mr Rees as a replacement to Mr Iemma.

Last night Ms Tebbutt, who quit the front bench last year to spend more time with her young son, Nathan, did not rule out a comeback. "I'll be talking to my colleagues over the next 24 hours and at the moment I am still thinking about things," she said.

Mr Watkins revealed that he was retiring from Parliament to become chief executive of the NSW branch of Alzheimer's Australia. He had told Mr Iemma of his plans to quit just hours earlier.

The reshuffle is expected to see Frank Sartor dumped from planning. The Health Minister, Reba Meagher, also faces an uncertain future.

Mr Watkins's retirement also forces a byelection in his seat of Ryde, which he holds with a 10 per cent margin, but could swing to the Liberals.

The Premier confirmed that the Left caucus would maintain its tradition of selecting the deputy premier and it is understood that the faction may nominate the Local Government Minister, Paul Lynch, if Ms Tebbutt does not put her hand up for the job.

It is also understood Mr Rees has been offered Mr Watkins's transport portfolio and Ian Macdonald will take over planning. David Campbell is likely to retain the police portfolio and John Hatzistergos will remain Attorney-General.

The suspended Education Minister, John Della Bosca, is expected to return to cabinet after the NSW Director of Public Prosecutions yesterday ruled out charges against him or his wife, the federal MP Belinda Neal, over the Iguanas nightclub incident.

Mr Iemma has maintained that Mr Della Bosca would be welcome back on his front bench if he was cleared by police but it is not known whether he will return to education or will be moved to another portfolio.

A former mayor of Parramatta, David Borger, is expected to be elevated to the front bench to fill the vacancy created by his Left colleague, the former Rural Fire Service chief Phil Koperberg, who stepped down from cabinet earlier this year because of ill health.

But Mr Iemma will be forced to make some tough decisions which could include demoting his close friend, the Juvenile Justice Minister, Barbara Perry to the back bench along with the Gaming and Racing Minister, Graham West.

Mr West's ministerial career has been in doubt since he admitted to a budget estimates hearing last year that Mr Iemma had personally asked him to look at introducing the international online gambling agency, Betfair, to NSW.

One senior government source said: "This is Morris's last chance. He either does a sweeping reshuffle or he is over."

Mr Iemma said his new front bench would be decided tomorrow after a meeting of his caucus members but he refused to be drawn on who would be dumped or promoted.

"This is an opportunity, and we'll be taking that opportunity to freshen up the Government," Mr Iemma said.

"I've always said I thought it was a matter of great regret that Carmel couldn't, for family reasons, recontest the cabinet positions after the election. I've always said it would be terrific to have her back."

Although his decision took his colleagues by surprise, it has been expected that Mr Watkins would retire before the next election.

Mr Watkins said he had served in eight portfolios "including most of the big ones" but it was time for him to embark on his third career.

"I had decided that this would be my last term some time ago and expected to serve for about another year but an unexpected opportunity has come my way with a non-government organisation I have got enormous respect for," he said.

Mr Iemma paid tribute to Mr Watkins's compassion, saying he was "always a voice of reason and commonsense, a man of great warmth and personal dignity".