Tony Blair, in a Commons statement on the European Council in Vienna, said the Conservative leader's policy was determined by the "headbangers" who served in his Shadow Cabinet.
Earlier, Mr Hague attacked the Prime Minister's denial that there would be uniform tax rates within the European Union, saying the Prime Minister's "habit of saying one thing to an audience in one place and another to an audience in another place is catching up with him".
Mr Hague agreed there was an "overwhelming case" for duty free sales to be kept, but attacked Mr Blair for "going with the flow" in his discussions with EU colleagues.
"Can you confirm that while you were telling the British media that the rebate was not up for negotiation, you were busily telling the Austrian media that there would be wide-ranging negotiations in which the rebate would come up for discussion?
"Wouldn't that be a much more effective way to ensure your thoughts are reported accurately than whining about the British press."
Rather than making pledges on uniform tax rates, Mr Blair should have insisted on an end to tax harmonisation, the Tory leader said, adding: "Wouldn't arguing against these real threats have demonstrated more backbone than arguing against imaginary threats?"
Replying, Mr Blair said it was "perfectly sensible" to try to reform some European tax practices as they were "harmful to this country".
"If the Tories were in power today, we would not have an ally anywhere, no influence, no authority, no ability to get our own way ... under your leadership the lunatics have taken over the asylum. You're not running your party. The policy of your party is determined by the headbangers you have surrounded yourself with in the Shadow Cabinet"
"This country's national interest lies in being part of Europe. That's the way to win in Europe and that is what this Government shall do," he added.
Menzies Campbell, Liberal Democrat foreign affairs spokesman, welcomed Mr Blair's "apparent recent conversion to the view that government policy in Europe is determined by what is best for Britain, and not what is least offensive to certain newspaper proprietors".
Gerald Kaufman, the former Labour minister and MP for Manchester Gorton, said "the best way to gain concessions, such as on duty free or the beef ban" was not by "the tantrums and boycotts in which the other side indulged when in Government, but by co-operation and winning over friends".Reuse content