The results announced by the election committee after counting of 99.6 per cent votes showed that the right bloc and centre-left bloc (including Arab parties) were evenly tied at 60 each in the 120-seat Knesset (Israeli parliament), figures that defied all pre-poll forecasts that had predicted a sweeping victory for Netanyahu for the third time.
President Shimon Peres is expected to ask Netanyahu to attempt to form a new government.
His Likud-Beitenu alliance lost a quarter of its seats in parliament, but remains the largest grouping with 31.
Netanyahu, 63, has offered to work with the newly-formed Yesh Atid (There is Future) party led by Yair Lapid, which shocked observers by coming second with 19 seats.
Lapid, a 49-year-old former scribe had joined the political race only last year by forming the Yesh Atid party, which has emerged as the new kingmaker.
He is expected to play an important role in the formation of the next government.
The unexpected results have forced the 63-year-old Netanyahu to scramble for support outside his natural allies which critics feel augurs well for the Middle East peace process that he shunned during his last four years.
Netanyahu called for early elections some three months ago, buoyed by opinion polls and sensing an easy victory but a chain of events during the campaigning period saw him struggling to retain power despite forming a joint list with former foreign minister Avigdor Lieberman's Yisrael Beteinu party.
The joint Likud-Yisrael Beiteinu list was able to secure a mere 31 Knesset seats, a significant drop from the 42 they together had in the previous parliament.
Netanyahu gave a victory speech shortly after midnight, saying, “I'm proud to be your prime minister. I thank you for giving me a chance, for the third time, to lead the State of Israel. It is a great privilege and a great responsibility.”
He vowed to form as broad a coalition as possible saying that the next government would be built on principles that include reforming the contentious system of granting draft exemptions to ultra-Orthodox Jewish men and the “responsible” pursuit of a “genuine peace” with the Palestinians.
The outcome of yesterday's poll largely showed that Israeli voters were more concerned about bread-and-butter issues over the ambitions of hardliners and largely ignored foreign policy issues like halting Iran's nuclear programme and Palestinian aspirations for statehood.
In his speech, Netanyahu said preventing Iran from developing nuclear weapons would remain his top priority. But internationally, he has repeatedly clashed with allies over his handling of the peace process.
Lapid has said he would only join a government committed to sweeping economic changes and a serious push to resume peace talks with the Palestinians.
Lapid was the first one to get a call from Netanyahu after exit polls forecast a strong show by his party.
Political analysts say coalition building will not be easy for Netanyahu.
The prime minister will need the support of Lapid, who wants to cut the privileges enjoyed by ultra-Orthodox Jews - about 10 per cent of Israel's population - but also the parties which have traditionally defended those privileges, they said.
The 19th Knesset has 31 seats for Likud - Beiteinu, Yesh Atid as the second biggest party with 19, Labour in third place at 15, with Shas and Bayit Yehudi at 11 seats each, the Central Elections Committee announced.
Religious United Torah Judaism party won seven seats, and former foreign minister Tzipi Livni's Hatnua (The Movement) Party and Meretz received six seats each.
Among the Arab parties, UAL - Taal got five, Hadash four, and Balad three.
The biggest losers of the polls was the largest faction in the 18th Knesset, Kadima, which barely managed to pass the threshold winning two seats, a massive fall from 28 seats in the outgoing Knesset.
The Israeli public, especially the middle class, has sent a clear message to its leadership in no uncertain terms - they cannot be held hostage to threats, both real and imagined, and there is a need for inward-looking.
The pent-up anger in the middle class was vented out only on the day it mattered, the day of the polling, falsifying all speculations and opinion polls, analysts said.
Netanyahu centered his campaign on the issue of security, primarily the Iranian threat, and as the leader who could stand up to international pressures and criticisms but the message didn't gel with the middle class reeling under the weight of rising costs.
The young and innovative parties fared well as they could better align their message with the aspirations of the masses and the larger established ones struggled as their leadership remained detached from the ground reality.
Some critics are already baying for Netanyahu's head calling him a “loser” who must go even though his partymen have put up a brave front and are backing him as the Prime Ministerial candidate.
It remains unclear when and how the next coalition will be formed but the stunning results of the elections are definitely a big blow to the right-wing bloc which was expected to register impressive gains this time.
The need for "change" is clearly imprinted on the elections results. The electorate said YES to political novices, Yair Lapid of the Yesh Atid party and Naftali Bennett of Bayit HaYehudi, making them the new poster boys and rejected the old guard - Netanyahu, former foreign ministers, Tzipi Livni and Avigdor Lieberman, and Shaul Mofaz the leader of the Kadima party.
A vote for a dramatic change in the country's diplomatic and security direction would have meant choosing one of the old guard but it was clearly not the main issue for voters in these elections.
The voter turnout this time was also over 66 per cent, which shows a nation not apathetic and disengaged, as many claim, but engaged and concerned.
It was the highest turnout of voters in the last ten years.
This engaged and concerned electorate is also aware of the external challenges Israel faces - from Iran, which calls for the country's destruction, to an Egypt with a President who calls Jews the descendants of apes and pigs, to an imploding Syria, to the Palestinian crisis - but still voted en masse for candidates who made those issues secondary in their campaigns.
Political analysts explained that this is because Israelis do not feel they can necessarily impact those issues while on the other hand they feel they can certainly make a difference in tackling internal problems.