That setback was seen as a vote against Netanyahu's hawkish leadership and one that could breathe life into a peace process with the Palestinians.
It's also possible the perceived nuclear threat from Iran and the possibility of a pre-emptive Israeli strike, a central issue for Netanyahu, will be downgraded as a political-security topic in the changed political landscape.
Netanyahu emerged from Tuesday's polling with the narrowest of victories for his right-wing religious bloc against an upstart centrist party formed in 2012 and led by a political newcomer, former television talk show host Yair Lapid.
Netanyahu's Likud Party and its ally, Yisrael Beiteinu of former Foreign Minister Avgidor Liberman, notched 31 seats in the 120-member Knesset, 11 fewer than they had held.
The centrist Yesh Atid -- "We Have a Future" in Hebrew -- won 19 seats against all predictions in its debut outing, making it the second largest party in the new Parliament.
Labor, once Israel's dominant party and the left's standard bearer, took third place with 15.
Israel's media largely portrayed the result as a pyrrhic victory for Netanyahu, who called the election seeking to consolidate his hold on power in a year he's declared will see Israel and the West confronting Iran over its alleged nuclear arms program.
Despite widespread predictions the right wing, including the far-right nationalist party Jewish Home, would score heavily, it fared badly. Jewish Home won 11 seats, as did the ultra-orthodox Shas.
Neither Iran nor the peace process was a significant issue during the election campaign, which focused on economic and social issues.
Netanyahu, who became prime minister for the second time in 2009, has persistently dragged his feet on the peace process, despite prodding by U.S. President Barack Obama.
The process stalled in 2009 when Netanyahu returned to power. Since then, he's refused to yield on the occupied West Bank and raised tensions before the election by ordering the construction of 4,500 more settler homes.
But his coalition will need to embrace parties beyond its natural right-wing allies if he's to have any hopes of serving a full term, and that could mean he'll have to make some concessions to the increasingly frustrated Palestinians' demand for statehood.
Lapid's Yesh Atid party, with whom Netanyahu will have to negotiate in the days ahead, supports a return to negotiations with Palestinian President Mahmoud Abbas' administration in the West Bank.
Netanyahu reportedly telephoned Lapid to discuss a possible alliance, telling him, "We have the opportunity to do great things together."
Asked whether Yesh Atid would consider joining the coalition, senior party official Karin Alharar commented: We're not saying no to anything. We're not saying yes either."
Lapid's being rumored as a possible candidate for foreign minister, a post until recently held by Lieberman, an outspoken opponent of relinquishing the West Bank.
The new Parliament, evenly split between the right and the centrist-left parties, may find itself locked in combat over an old-new issue in the peace process: Israeli annexation of the West Bank, as it annexed Syria's Golan Heights and Arab East Jerusalem after 1967.
Although Netanyahu assiduously avoided the peace process during the electioneering, two of his close Likud associates, Yuli Edelstein and Zeev Elkin, have been openly touting annexation.
Leading right-wing activist Nadia Matar says that annexation -- a proposal that's been kicking around for some time -- is an idea whose time has come.
"Everybody understands that the two-state solution is national suicide" for Israel, "but we can't leave a vacuum," she told the U.S. Jewish daily the Forward.
Israel's religious Jews, including the powerful settler movement in the West Bank, say the territory was given to the Jews by God and cannot be surrendered.
"What we're calling to do was done 45 years ago in Jerusalem, when everyone said the skies were going to fall in -- and they didn't," Matar said.
Reviving this issue may help Netanyahu, who hasn't publicly endorsed the idea, in his battle to stay on top but with Palestinian anger rising, and international isolation growing, it could also backfire.