The furore centres on the impending transfer of public assets to the private sector in the Labour-controlled London borough of Islington, spiritual home to New Labour and site of the former residence of Prime Minister Tony Blair.
The criticism, from the Labour MP for Islington North, Jeremy Corbyn, is a blow to the Government's attempts to present a united front on one of its most important policy initiatives. Corbyn calls the impending transfer of assets "a great mistake".
Islington council hopes to save millions of pounds a year by handing its refuse collection service over to a joint venture run by the council and the pounds 90m-a-year construction and services group John Doyle.
But the deal has unleashed a storm of protest from unions, local people and Labour Party members who accuse the Labour council of betraying workers and selling off the family silver.
At the heart of the controversy is an agreement by the council to allow John Doyle to use one of its prime assets, an enormous four-storey vehicle depot in the heart of London, rent-free, for the next 10 years. About half of the depot will be taken up by the refuse vehicles, says the council, but John Doyle will be free to develop the rest commercially.
"There is a lot of anger about it," says Mr Corbyn. "They are getting a huge depot, with the potential to become a rail access point because of the nearby railway lines. It is just in the right place if the company gets contracts for the King's Cross/St Pancras development," he says. "The feeling locally is that John Doyle is getting a very cushy deal."
John Doyle has guaranteed to save the council about pounds 800,000 a year on its pounds 7.5m refuse disposal bill. The council stands to earn around another pounds 1.5m a year once its application for PFI funding is approved. And John Doyle has agreed to invest pounds 15m in the depot and the council vehicles at a time when the council is having to find pounds 9m of cuts in its own budget.
"We could have entered into a joint venture simply to rent out space and kept the refuse collection in-house," says Labour councillor Liz Davies. "I don't think the services delivered will be as good as the services delivered by the council. I can't see how they can deliver a better service at a lower price."
As concern grows among the trade unions, residents of Islington are bearing the brunt of the controversy. A five-day strike by the 240 refuse workers affected left the streets of Islington strewn with rubbish earlier this month and further strikes are threatened in the coming weeks.
"We are concerned that John Doyle has given no guarantees that our members will have the same pension rights when they transfer to the joint venture or that they will have the same long-term job security," says a spokeswoman for the GMB trade union.
The council said it was finalising negotiations with John Doyle to take a share of up to 19 per cent in the joint venture and to have a possible right to veto some decisions which affect staff pay and conditions.
John Doyle said in a statement that its track record in looking after its employees "stands up to the closest scrutiny".