The move, though expected, angered Post Office chiefs and placed a question mark over the flotation of ICL, the computer services company leading the project.
The Horizon project, being developed by ICL Pathway as a way of curbing social security fraud, is three years behind schedule and an estimated pounds 300m over budget and is still only in operation at 250 out of Britain's 19,000 post offices.
In a statement last night, the Secretary of State for Trade and Industry, Stephen Byers, said that the Government had decided to abandon plans to pay benefits at post offices using the electronic swipe card developed by ICL.
However, in what he claimed was a move to put the project "back on track", he said that ICL would continue with plans to computerise the Post Office Counters network by 2001, and claimed that savings in benefit fraud of pounds 100m would still be achievable.
The Post Office's chief executive, John Roberts, was said last night to be furious at the decision.
Post Office chiefs fear that the network will lose customers as more benefits are paid direct into banks, hitting revenues and putting hundreds of rural branches in danger of closure.
The fixed price contract with ICL Pathway will continue to run until 2005 but the terms will be revised so that payment is no longer linked to the volume of business transacted.
The Horizon project, which was awarded to ICL in 1996 by the previous government, should have been in operation a year ago, dispensing 690 million benefit payments a year with claimants using a magnetic strip swipe-card.
But yesterday the Benefits Agency said it had decided not to proceed with this system and will instead fall back on the use of bar-coded payment books until the move to automatic credit transfer of payments into bank accounts can be achieved.
ICL put a brave face on the announcement, maintaining that the contract with the Benefits Agency had only ever been part of a wider project. ICL said that the Horizon project's sole customer will now be the Post Office and that it would proceed with the rollout this summer of automated technology in all 19,000 branches, completing the program in 2001.
Privately, ICL executives blamed the fact that it had had two clients - the Benefits Agency and the Post Office - for some of the delays in the program.
ICL had been demanding increased toll payments from the Benefits Agency to compensate for the increased cost of the project. But Alistair Darling, the Secretary of State for Social Security, is understood to have rejected this on the grounds that it would cancel out the savings made by reducing fraudulent benefit claims.