The letter, to the then prime minister, Margaret Thatcher, from Nicholas Ridley, her Secretary of State for Trade and Industry, is part of the mountain of evidence presented to Sir Richard's Scott's arms inquiry. It reveals that ministers were embroiled in Cabinet in-fighting over the policy.
It also shows how senior ministers were aware of the independent investigation by Customs and Excise officers into breaches of the embargo by British firms - and feared that if it went ahead, it could seriously damage relations with Iraq.
John Major, then Chancellor, also received a personal copy of the Ridley letter, which was sent to senior Cabinet ministers less than six weeks before Iraq invaded Kuwait.
News of the existence of the confidential four page document is certain to increase pressure for the swift publication of the Scott inquiry into Britain's arms trade with Saddam's regime. Sir Richard's latest estimate is that his report will be published in January.
Paddy Ashdown, the Liberal Democrat leader, wrote to Mr Major soon after the Scott inquiry was established in late 1992, citing the Ridley memorandum and asking whether Mr Major had lied when he had said earlier that the Government's guidelines had been observed. Mr Major replied that it was up to the Scott inquiry to establish whether the system of guidelines had "operated as it should have done and the right decision taken".
The letter discloses that :
t A rift had developed between the Foreign Office, which wanted to maintain an embargo not just on arms but also on machine tools, which could be adapted for use in the manufacture of arms, and the DTI, which feared that the machine tool ban would wreck British trade relations with Iraq.
t Saddam's son-in-law had just told the British Ambassador that the UK was interfering with civil trade and encouraging other countries to follow suit. This apparently confirmed Saddam's impression that Britain was applying an embargo going well beyond arms. Mr Ridley feared that Iraq was about to cut all business links.
t Iraq had two months earlier suspended payments on pounds 1bn it owed Britain and was already pounds 140m in arrears. The DTI feared it might now default on the entire amount, which, said Mr Ridley, would have serious consequences - not just for the Government's Export Credit Guarantee Department (ECGD) but for public sector borrowing.
t Ministers were aware of a Customs and Excise probe into one British firm which had supplied machine tools to Iraq, Matrix Churchill. Ministers feared that the Customs investigation would worsen relations which were already strained.
t Many of the machine tools which the Foreign Office wanted to ban were widely available on the international market. Britain had even agreed at this point to supply them to Eastern European regimes and the Soviet Union. Mr Ridley feared that the equipment would be sold to Iraq by other countries with a less rigid interpretation of the embargo and as a consequence, British firms would lose out.
Baroness Thatcher said in her evidence to the Scott inquiry, that she knew nothing of the details of how the arms embargo worked. Only the big things came to her. "Most of the documents before me [at the inquiry] I have never seen. I was concerned with the big issues," she said. "If I had seen every copy of every minute when I was in government, I would have been in a snowstorm."
Yet if she knew nothing of the detail, the Ridley letter now shows she certainly was privy to the policy disagreement between the Foreign Office and the Department of Trade.
It also reveals that copies of the letter were sent to "members of OD" - the Cabinet Overseas and Defence Committee of which Mr Major was at the time a member in his capacity as Chancellor.
Mr Major told Lord Justice Scott that he had not seen a series of Cabinet documents discussing defence sales to Iraq - which included references to the Customs investigation into Matrix Churchill - days before Iraqi tanks moved into Kuwait. Mr Major said he was not shown the documents because he did not attend the meeting to discuss trade with Iraq.
Nevertheless, Mr Major was aware of the Matrix Churchill investigation and referred to it in his letter to Mr Ashdown. A copy of Mr Ridley's letter to Lady Thatcher was sent to all OD members - including Mr Major.
When the letter was written - on the same day that Customs and Excise investigators interviewed managers at Matrix Churchill - the British security services were unaware of Iraq's hostile intentions towards Kuwait.
There was, however, considerable public anxiety about the conduct of the Iraqi leader. A ceasefire had been agreed in the Iran-Iraq war two years before, but a year after that, Saddam had outraged the world by gassing his own citizens, in the northern Kurdish region.
Only three months before the letter was written, the Observer journalist, Farzad Bazoft, whom the Iraqis accused of spying, had been executed. Bazoft's travelling companion, nurse Daphne Parish, was still imprisoned, and British businessman Ian Richter had been in an Iraqi jail for five years - all of which had caused considerable public indignation in Britain.
Despite all this, Mr Ridley, who died in March 1993, concluded by calling for the entire policy of maintaining an arms embargo to be reviewed. "I see a strong case for a more thorough review of our policy in this area which would take into account the policy and political arguments in favour of export controls, the commercial consequences for British industry and the financial risks for ECGD of continuing friction in our relations with Iraq," the letter concluded.
Last night Mr Ashdown said: "I have always been concerned about this letter because it goes to the heart of the issue and highlights the extent of Government disarray on the policy. The Prime Minister did not answer my questions at the time and has never answered them. It is vital that Sir Richard Scott produces his report as quickly as possible so that we can finally get to the bottom of this scandal".
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