Ashworth hospital on Merseyside, which houses 456 mentally disordered patients including the Moors murderer Ian Brady, became a centre for the copying and distribution of hard-core porn in which an eight-year-old girl was being "groomed for paedophile purposes", according to an inquiry.
Frank Dobson, the Secretary of State for Health, painted a chilling picture of an asylum taken over by its inmates, which left MPs shocked and dismayed. He described it as a "shameful story of confusion, indecision, mismanagement and incompetence". But he rejected the key recommendation in the 600-page report of the public inquiry team under a judge, Peter Fallon QC, to close down Ashworth, and by implication its sister hospitals, Broadmoor and Rampton, "at the earliest opportunity".
It emerged, however, that Ashworth could be broken into smaller segregated units. The inquiry report, which included 55 recommendations, is also likely to lead to sweeping changes in the law, including new powers to allow the Secretary of State to sack NHS staff, and tougher controls over patients with personality disorders.
The nine-month pounds 7.5m inquiry - triggered by allegations from Stephen Daggett, a convicted child abuser who absconded from the hospital in 1996 - found pornography was "widely available", security was "farcical" and the whole unit "deeply flawed". The inquiry said the hospital was dominated by "clever and manipulative" inmates.
Mr Fallon - who said the whole system was "rotten" - concluded: "The hospital's negative, defensive and blame- ridden culture is so deeply ingrained that we doubt even the most talented management team could turn it around. Ashworth hospital should close at the earliest opportunity."
He said: "The management culture of the hospital was dysfunctional. Senior managers were secretive, out of touch and totally unable to control this large institution. We therefore have no confidence in the ability of Ashworth Hospital to flourish under any management. It should close."
But Mr Dobson told the Commons that the institution's problems were not those of "bricks and mortar" but of management and gave the hospital four months to turn itself round.
The first heads to roll yesterday were Paul Lever, chairman of the Ashworth Hospital Authority, and Anne Marie Nelson, former chairman of the Special Hospitals Service Authority and chairman of the High Security Services Commissioning Board. Twenty three members of staff named in the report could be sacked or face professional disciplinary action. A former admiral in the Royal Navy, Ian Pirnie, chairman of the Morecambe Bay health authority, was appointed to take over the authority.
The most disturbing part of Mr Fallon's report described how an eight- year-old girl was smuggled into the hospital between 1994 and 1996 "weekend, after weekend" by her own father, a former inmate of Ashworth who is now prevented by a court order from contact with her.
"The child at the centre of the paedophile allegations was, in our view, being groomed for paedophile purposes. This is a disgraceful situation in what was supposed to be a hospital, and a high-security hospital at that," said the report.
Yesterday the Government secured a court order to protect the girl's anonymity. Mr Dobson told MPs: "I have checked. She seems to be doing pretty well. She is living a settled life."
The report found that drugs and pornographic videos were freely available; the father of the girl brought pornographic videos into the hospital; several patients had credit cards and were able to borrow large sums of money; and a machine for embossing share certificates was uncovered - leading to the uncovering of "scams and money-making ventures in the personality disorder unit". A confectionery and soft drinks stall for patients saw turnover in 1996 soar from pounds 50 a month to pounds 14,000.
Members of the inquiry team were clearly disappointed with Mr Dobson's refusal to close Ashworth. They have recommended that patients with personality disorders are treated in smaller separate units away from other mentally ill people and have advocated wide-scale reform of what they called a "rotten" system.
Asked how he felt about Mr Dobson's decision, Mr Fallon would only say: "Frankly, we disagree ... If Ashworth and other special hospitals continue to be structured and run as they currently are, we envisage the problems will return."