Chrysler has filed for Chapter 11 bankruptcy protection and also formed an alliance with Fiat which will see the Italian company take a 20% stake.
The White House described the decision as a "surgical short bankruptcy" which should last between 30 and 60 days.
US president Barack Obama said the government had "worked very hard to avoid this", but blamed Chrysler's lenders for not wanting to participate in a deal to stop it from entering into Chapter 11.
Obama reiterated that Chapter 11 would not effect customers buying or servicing cars from Dodge, Jeep or the Chrysler brands.
Fiat will take a 20% stake, with the possibility of it rising to 35% if performance targets are met. It could reach 51% by 2016 if Chrysler's government loans are fully repaid.
The deal at a glance
- The Treasury will have an 8% stake, a union-run trust fund VEBA will take a 55% stake, and the governments of Canada and Ontario will gain a combined 2% stake
- Current owner Cerberus will forfeit its 80.1% stake
- Daimler will give up its remaining 19.9% stake in Chrysler
- The new company will be run by a nine-person board, with six picked by the government and three by Fiat. The board will pick a new chief executive.
US officials said the Treasury Department will provide Chrysler with $3 billion (£2bn) to $3.5bn (£2.36bn) in additional loans to fund operations during bankruptcy. The US government anticipates that it will provide an additional $4.5bn (£3bn) of financing to allow Chrysler to exit bankruptcy.
Chrysler CEO Bob Nardelli will step down once the bankruptcy process has finished.
Nardelli said: “I’m disappointed that we had to file for bankruptcy. It certainly wouldn’t have been my choice, but given the where we are it’s certainly the only path.
“We want to personally assure everyone that the new company will produce and support quality vehicles under the Jeep, Dodge and Chrysler brands.
“Chrysler employees will become employees of the new company. Chrysler dealerships remain open for business serving our customers. All vehicle warranties will be honoured without interruption and consumers can continue to purchase our vehicles with complete confidence.”
Sue Robinson, director of the RMI’s national franchised dealers association (NFDA), said: "Although UK Chrysler dealers will be concerned about the manufacturer’s move into bankruptcy protection, the move will give dealers time to assess their own situation and make any changes they feel necessary to secure the future of their own businesses.
"The NFDA is in the process of contacting all its Chrysler dealer members so that they know that support and advice is available if required."
Analysts have stated that Chrysler and its co-op partner Fiat preferred to go into Chapter 11 in order to give its lenders less money.
US Chapter 11 bankruptcy protection gives a US company time to rearrange its finances under a court-supervised procedure, while continuing to trade, protected from its creditors.
Chrysler's bankruptcy will further impact consumer confidence with the manufacturer's brands in the UK as customers become uncertain about the future of the business. If the company can bounce back with help from Fiat, it will take time before customer confidence will return.