Civil service trade unions have accused the Government of hypocrisy over the deal, and Labour MPs have demanded an explanation from Kenneth Clarke, the Home Secretary.
Beck and Pollitzer, part of the Transport Development Group, won a pounds 3m contract to manage the Prison Service supplies and transportation department last July. But the deal collapsed when the Attorney-General stated that under EC rules the company had to honour civil servants' existing pay and conditions. Beck and Pollitzer had planned to recruit redundant civil servants on different pay and conditions. The fiasco has cost the Home Office pounds 620,000 in redundancy payments to 89 staff.
The contract was the first exercise in 'market testing' - forcing civil service managers to compete with private companies for their jobs. The management of Strangeways prison in Manchester is next in line for market testing.
On 24 March, days after the deal collapsed, Beck and Pollitzer was offered a new consultancy contract, for which it was not required to bid. The company considers the new deal, estimated to be worth about pounds 500,000, 'compensation' for the loss of the pounds 3m contract.
John McAllion, Labour MP for Dundee East, has called for the matter to be referred to the Public Accounts Committee. 'The whole question of the propriety of market testing, and the misuse of taxpayers' money to aid the Government's ideological attack on public service, needs to be examined as a matter of urgency,' he said.
John Sheldon, general secretary of the National Union of Civil and Public Servants, called for the market testing programme to be halted. 'This episode combines incompetence, waste of public money and political zealotry in equal measures,' he said.
Under the EC's Public Services Procurement directive, which comes into force in July, all government contracts must be put out to competitive tender.
A spokesman for Beck and Pollitzer said: 'We had a contract which was due to begin in April, but because of difficulties with the EC directive, we now have a much-watered-down contract to put into place the kind of steps we would have under the old contract.
'We look at it as compensation . . . We are being compensated for a loss of profits. From our point of view it is not nearly enough, but there is nothing else we can hope to gain. We asked in the early stages if the directive would apply. We were told it did not. Later we were told it did.'
A Home Office spokesman said: 'We did not have time to tender out the second contract. The procedure was approved by our contracts section. We are not using the phrase 'compensation'.'