"No one will survive," the driver was quoted as saying by Italian police.
However the children, some of them tied up, were rescued through smashed windows at the back of the bus and no-one was badly hurt. Fourteen people suffered smoke inhalation.
The driver, a 47-year-old Italian citizen originally from Senegal, was arrested.
"It was a miracle, it could have been a massacre," Milan chief prosecutor Francesco Greco was quoted as saying.
A teacher who had been on board the bus said the suspect was known to be angry about Italy's migrant policy. Some reports said the man had shouted "stop the deaths in the Mediterranean".
The driver had been taking two classes of teenagers and their adult escort from a school in Vailati di Crema to a gym but took a different route on a provincial highway apparently heading for Milan's Linate airport, local reports said.
The ordeal then unfolded over the next 40 minutes.
Witnesses said that when he began addressing the passengers with a knife, a boy phoned a parent, who alerted the police.
It took some time before police tried to intercept the bus. The vehicle rammed into police cars before slowing down.
Italian reports said the driver had sprinkled petrol around the bus but police were able to smash the rear windows and let the passengers off before it burst into flames.
Milan prosecutors said they were investigating all possible motives including terrorism.
Italy's right-wing interior minister, Matteo Salvini, reacted with outrage that a man with a record of driving while under the influence of alcohol could have been allowed to drive a coach full of children.
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