Transport Secretary Philip Hammond announced that the £6 billion procurement programme to replace the RAF's Sea King fleet was being halted because the preferred bidder has admitted it had access to commercially sensitive information.
Ministry of Defence police are now investigating how the information came to be in the possession of CHC Helicopter, a member of the Soteria consortium.
Former Liberal Democrat leader Sir Menzies Campbell said that the debacle raised questions over the movement of staff between the MoD and private companies.
"What it will raise once again is the nature of the relationship of the people who work for the MoD and commercial organisations," Sir Menzies told BBC Radio Scotland.
Under the privatisation plans, Soteria would have provided US Sikorsky helicopters to fly search and rescue missions from 12 bases around the UK currently operated by the Royal Navy, RAF and coastguards.
The scheme sparked controversy, with Prince William - who has been serving as a Sea King pilot at RAF Valley on Anglesey - understood to have voiced his concern to Prime Minister David Cameron when they met in Zurich as part of England's 2018 World Cup bid in December.
Ministers are now considering the potential options for maintaining cover until new longer term arrangements can be put in place, with speculation that they may go for an upgrade of serving Sea Kings.
Maritime and Coastguard Agency chief executive Vice-Admiral Sir Alan Massey said today's development would have no immediate impact on the service, though he expressed concern about future rescue capabilities.
"I am completely satisfied with the service our search and rescue helicopters provide at the moment," he told MPs on the Commons Transport Committee.
"I have no concerns today. If you ask me how things are going to be in 2016 it might be different."
Concerns about the Soteria bid first emerged in December, when Defence Secretary Liam Fox disclosed that information had come to light which "required clarification".
In today's statement to Parliament, also released to the London Stock Exchange, Mr Hammond said: "The Government has sufficient information to enable it to conclude that the irregularities that have been identified were such that it would not be appropriate to proceed with either the preferred bid or with the current procurement process.
"The Department for Transport and the Ministry of Defence will now consider the potential procurement options to meet future requirements for search and rescue helicopters in the United Kingdom, including options to maintain continuity of search and rescue helicopter cover until new longer term arrangements can be put in place."
The statement disclosed that a former member of the joint MoD and Department for Transport (DfT) project team had gone on to advise the consortium on its bid preparation, contrary to explicit assurances given to the project team.
Even before the MoD police investigation has concluded, the Government had sufficient information to determine that it would not be "appropriate" to continue with the preferred bid or the current bidding process, said Mr Hammond.
Soteria said in a statement that it was "disappointed" to learn of the cancellation of the programme.
"Soteria is evaluating the Government's decision and if given the opportunity is confident that it is capable of delivering the SAR-H (search and rescue helicopter) programme and stands ready to work with the UK Government," said a spokesman.
Today's announcement fuelled earlier criticisms of the privatisation process.
Bob Crow, general secretary of the Rail, Maritime and Transport union, said: "This whole sordid and botched episode shows that the raw greed of the private sector should never be allowed anywhere near the life-or-death rescue services on the high seas.
"Millions of pounds of taxpayers' money has been wasted and the whole plan should now be scrapped, not shelved."
And Liberal Democrat president Tim Farron, whose Westmorland and Lonsdale constituency includes areas of the Lake District where hikers often have to call upon the services of rescue helicopters, described it as "a blessing in disguise".
The Government's privatisation plans would have reduced search and rescue coverage in south Cumbria from 24 to 12 hours a day, he said.
"It would have put the lives of many people on the mountains at risk and undermined the work of our excellent maritime rescue teams," Mr Farron told BBC Radio 4's World at One.
"This gives Number 10 the opportunity to think again and they have indicated they might just do that."
Brian Donohoe, Labour MP for Central Ayrshire, whose constituency includes the HMS Gannet search and rescue base, told BBC Radio Scotland: "I understand it is highly probable that there will be a proposal to have the Sea King, the present kit, upgraded in order that the service will be able to be maintained.
"The worst thing that can happen here is that the service to the public will suffer as a consequence of all these delays."
The Scottish National Party's defence spokesman at Westminster, Angus Robertson, said: "There have always been serious questions about privatisation of search and rescue services, including the loss of the military training and excellence of our RAF crews who make the fleet so effective.
"The abandonment of this process now raises serious questions for the UK Government. How much this failed process has cost the taxpayer, and what will now happen to search and rescue services given the road the Ministry of Defence is going down with base closures?"
Shadow defence secretary Jim Murphy said: "We respect the announcement that the Government is cancelling the proposed deal. The Labour shadow defence team has been calling for clarity for several months.
"It is important ministers now take this opportunity for a rethink and consider all options.
"People will want open discussion about more cost-effective alternatives in light of the changed fiscal environment and cuts made to our armed forces and defence equipment in the Defence Review.
"In particular, we must discuss how best to deliver this capability in future by harnessing new innovation, as well as whether upgrading the Sea Kings is an option and at what cost.
"We hope the Government will be open about the details of alternative bids they have received.
"If they are to proceed with an alternative consortium, people will want to know the impact on UK bases, the role of the military and whether this has an impact on other emergency services.
"It is vital that industry is properly consulted as a way forward is established, since maintaining industrial capabilities in the UK should be a Government priority.
"We would like to be informed, as appropriate, about the issue behind the cancellation and how they will be prevented from occurring in future."
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