Mr Gusmao, a former president and prime minister and still the most powerful figure in Asia's newest democracy, made the surprise announcement that his National Congress for Timorese Reconstruction (CNRT) party would not enter into a coalition with the leftist Fretilin party, which narrowly won the July 22 vote.

The parties have jointly ruled through a parliamentary majority alliance that Mr Gusmao set-up in 2015, saying at the time he favours a "government of national unity" for the stability it brings East Timor.

In a speech to a closed meeting of party officials, Mr Gusmao took blame for the party's loss and said the vote showed Timorese "do not trust the CNRT to govern," the Portuguese newsagency Lusa reported from Dili.

The CNRT won 29.5 per cent of the vote, down from 37.7 per cent in 2012, when it was the top polling party.

Fretilin this time captured 29.7 per cent of the vote and its leader Mari Alkatiri claimed victory.

But Fretilin fell short of winning the 33 seats needed in the 65-seat parliament for one party to rule alone.

Some analysts say Mr Gusmao's resignation may be part of a negotiating ploy and predicted he would probably still cut a deal with Fretilin.

But Mr Gusmao said his party "will not accept proposals from anyone, nor invite any party to form a coalition because it does not intend to participate in government," Lusa reported.

"This is the right moment for Fretilin, as the winning party of the 2017 elections, to assume, and with full legitimacy, the reins of government," he said, adding the CNRT would serve in opposition "to contribute to the process of nation building, to consolidate the democratic transition in this country."

Jose Ramos-Horta, East Timor's former president and prime minister, praised Mr Gusmao for "gallantly" honouring the people's verdict by accepting defeat and responsibility for the election loss.

"Xanana has elevated himself higher," Mr Ramos-Horta said on social media.

"Now it is simple. It is incumbent on Dr Mari Alkatiri to actively engage other parties in forging a government that will continue to consolidate peace and democracy in Timor-Leste (East Timor), build on many positive achievements the country has experienced, improve on what has been successful, change where it has to change," he said.

Referring to Fairfax Media's report that Mr Gusmao's decision has thrown moves to form a coalition government into "disarray," Mr Ramos-Horta said "Mr Murdoch like many other media cohorts never see anything positive whatever Timorese leaders do."

Many CNRT members believe Fretilin should allow the CNRT to name the next prime minister after the party supported Fretilin's Rui Araujo as the last prime minister and endorsed Fretilin's Francisco "Lu-Olo" Guterres, who won presidential elections in March.

Mr Alkatiri said the day after the election that his party will "do everything to embrace anyone and will continue to work with Xanana Gusmao, the inescapable figure of the country, in order to respond to the clear message from our people."

Michael Leach, an expert on East Timor from Swinburne University of Technology, said Fretilin's narrow victory has made the outcome of negotiations to form a government less predictable.

"But we should know the composition of a new government within a few days," he said.

Damien Kingsbury, an expert on East Timor from Deakin University, said East Timor went into the election with a general expectation that Fretilin and the CNRT would continue to dominate politics and return to the coalition that brought the country stability since 2015.

"That stability is now in question," he said.

"Timor-Leste's political unity that promised such stability now appears broken," he said.

Mr Gusmao has been leading East Timor's negotiations with Australia over a maritime border between the two countries that will decide the future of the Greater Sunrise oil and gas field in the Timor Sea.

With East Timor's income from existing oil and gas projects drying up in a few years, East Timor could be broke within a decade unless Greater Sunrise is developed.

Mr Gusmao has insisted gas from the field be piped to a yet-to-be built industrial complex in East Timor, but a Woodside-led consortium says this is unviable and wants to build a floating platform over the field.