Liam Fox's contacts with his self-styled adviser Adam Werritty constituted a clear breach of the Ministerial Code of Conduct, the Cabinet Secretary Sir Gus O'Donnell "said today.
In his report on the former defence secretary, Sir Gus said that Dr Fox should have declared details of his relationship with Mr Werritty to his permanent secretary at the Ministry of Defence.
He said Dr Fox's "close and visible association" with Mr Werritty and his misleading use of business cards describing himself as Dr Fox's adviser fuelled a general impression that Mr Werritty spoke on behalf of the British Government.
Sir Gus said there had been a "blurring of lines" between Dr Fox's private and official responsibilities which was "not appropriate and not acceptable".
Sir Gus strongly criticised Dr Fox for allowing Mr Werritty access to details of his diary covering overseas visits, saying it had "posed a degree of security risk" both to Dr Fox and his accompanying officials.
He said that both his private office at the MoD and his permanent secretary had raised with Dr Fox the risks of his association with Mr Werritty.
"Dr Fox took action in respect of business cards but clearly made a judgment that his contact with Mr Werritty should continue," he said.
"This may have been a reasonable judgment had the contacts been minimal and purely personal and had not involved Mr Werritty's frequent attendance at meetings in the MoD main building and on overseas visits.
"The damage arose because the frequency, range and extent of these contacts were not regulated as well as they should have been and this was exacerbated by the fact that Dr Fox did not make his department aware of all the various contacts.
"I also conclude that the links and a lack of clarity of roles means that the donations given to Mr Werritty could be seen as giving rise to the perception of a conflict of interest."
He said that Dr Fox should have made clear to his permanent secretary that Mr Werritty was a friend who had a company, Pargav, funded by a number of donors - some of whom had provided financial backing for Dr Fox when he was in opposition.
Sir Gus made a series of recommendations in response to the Werritty affair, including a new requirement for ministers to inform their departments whenever discussions on policy issues or contracts take place with external organisations without an official present.
On trips abroad, departments should make sure there is no confusion about who is part of the ministerial party and officials should accompany ministers to all meetings at which it is expected that official matters may be raised, he said.
On their appointment, ministers should inform their permanent secretaries of any acquaintances or advisers who have contractual relationships with the department or are involved in policy development, and take action to avoid any perceived conflict of interest.
And permanent secretaries should take responsibility for ensuring procedures are followed and raise any concerns with ministers, the Cabinet Secretary and ultimately the Prime Minister.
Downing Street said that David Cameron accepted all of Sir Gus's recommendations.
In a statement, Number 10 said: "The Prime Minister accepted Dr Fox's resignation and his reasons for resigning. He made clear that he was sorry to see the departure of a Defence Secretary who had implemented fundamental changes that will help to ensure our armed forces are fully equipped to meet the challenges of the modern era.
"Today's report makes clear that Dr Fox did breach the ministerial code.
"This Government has already introduced changes that significantly increase government transparency - publishing lists of meetings with external organisations and all procurement over £500.
"In this case, the MoD permanent secretary has accepted that there should have been much tighter procedures within the department and is taking steps to strengthen them to ensure that the ministerial code is properly adhered to in future.
"The Cabinet Secretary has now recommended further strengthening of procedures across Government. The Prime Minister accepts the Cabinet Secretary's recommendations and the Cabinet Secretary will write to Permanent Secretaries setting this out."
Dr Fox said in a statement: "I am pleased that the report makes clear that the two most serious allegations, namely of any financial gain sought, expected or received by myself and any breach of national security, have no basis.
"As I said in the House of Commons last week, I accept that it was a mistake to allow the distinctions between government and private roles to become blurred, and I must take my share of the responsibility for this.
"More care should have been taken to avoid the impression that anyone other than ministers and officials were speaking on behalf of the Government, as this was not the case.
"Although there were no actual conflicts of interest, I acknowledge that in order to avoid any possible perception of this, all private interests should have been fully declared to the Permanent Secretary.
"I welcome the recommendations in this report which will provide greater clarity for Ministers, officials and private individuals in the future."
Downing Street said that Sir George Young, Leader of the House, would make a statement on the report in the Commons tomorrow.
Pressed on why David Cameron would not be making that, as Labour had requested, a spokesman said: "He will be answering questions in prime minister's questions before that."
The report, which was published many hours later than expected, had been subject to rigorous checks, he added.
"This is Gus O'Donnell's report. Every dot and comma is his dot and comma. Clearly there has been a process of checking to ensure there are not factual inaccuracies.
"We had to go through the proper checks to ensure this report was accurate."
The prime minister's official spokesman also insisted it was "matter for Dr Fox" as to whether he accepted the pay off he is entitled to.
"In law, ministers when they leave office, are entitled to three months' severance, whatever the circumstances.
"We don't have any plans to change that."
He refused to say whether Dr Fox was likely to return to ministerial office at a later date but appeared to indicate that no further investigations would be ordered into his conduct.
The report listed Pargav's backers as Oceana Investment, Jon Moulton, G3 Ltd, Tamares, IRG Ltd and Michael Davis. It said that Mr Werritty also had another company, Todiha Ltd, which invoiced Pargav for Mr Werritty's services.
The report also disclosed that Dr Fox turned down an offer to take an official from his private office to a meeting with the defence supplier, Harvey Boulter, in Dubai last June.
He also rejected an offer to take an official to a private dinner with senior Israelis in Tel Aviv in February - although on that occasion the British ambassador was present.
"This should not have been allowed to happen. Ministers should respect the advice they are given particularly when there are security or propriety implications for the decisions they take," it said.
Sir Gus said that he had found no evidence that Dr Fox gained financially from his relationship with Mr Werritty and no evidence that Mr Werritty had had access to classified information.
Overall, however, he said Dr Fox had failed to live up to the standards of conduct set out in the Ministerial Code which require ministers "to act in the national interest, above improper influence, and to serve to the highest standards of conduct".
"The Ministerial Code requires ministers to ensure that no conflict arises, or could reasonably be perceived to arise, between their public duties and their private interests, financial or otherwise," he said.
"Dr Fox's actions clearly constitute a breach of the Ministerial Code which Dr Fox has already acknowledged. This was a failure of judgment on his part for which he has taken the ultimate responsibility in resigning office.
"The Ministerial Code sets out very clearly the standards of behaviour required from Ministers. Dr Fox did not live up to these standards which he has since acknowledged."
Shadow defence secretary Jim Murphy dismissed Sir Gus's inquiry as "superficial and narrow" leaving serious unanswered questions which the Government had to address.
"This report only scratches the surface of potential wrongdoing. This is a murky business and it has not yet been resolved," he said.
"We need to know the role and influence of Liam Fox's 'unofficial adviser', the nature of any solicited donations and the full extent of Adam Werritty's funding and the access he had.
"The Prime Minister must give the British public a categoric statement that he is certain that no similar practices are taking place anywhere else in his government, and must confirm that he did not know any of the facts that have come to light since Dr Fox's statement on October 10."
Sir George told Channel 4 News: "It's quite clear what went wrong. Warnings were given to Dr Fox by his department and he chose to ignore them and then nothing happened.
"One of the key recommendations by the Cabinet Secretary was that should that ever occur again it should be escalated, firstly to the Cabinet Secretary and ultimately to the Prime Minister."
He dismissed questions over whether Dr Fox would ever return to the frontbench as "way beyond my pay grade" but said he hoped the party could "harness his talents and energies in some way".