In the frame: The 'cash for peerages' inquiry is widening. The next knock at the door may be at No 10

Arrest of head teacher has thrown the spotlight on one of the projects closest to Tony Blair's heart. Were multimillionaires courted to fund schools in exchange for honours? Marie Woolf and Francis Elliott report

The respected head teacher, serving the last few weeks before his retirement, could have had little idea of what lay ahead as he began his breakfast that morning in the Wanstead home he shares with his wife, Delia, and teenage son.

Within hours, however, news of his arrest was sent to the world's media, sending shock-waves through the upper echelons of the Labour Party and its wealthy friends.

The story of how a head teacher, previously best known for restoring discipline to his Roman Catholic secondary school, became a pawn in the cash-for-honours investigation starts in a London restaurant earlier this year.

After a glass or two of champagne, Mr Smith is alleged to have told an undercover reporter that a peerage was "a certainty" for any individual prepared to give £10m to Tony Blair's pet education project, city academy schools. He was acting as an adviser to the Specialist Schools and Academies Trust (SSAT), a body part-funded by the Government to encourage the growth of such schools.

Mr Smith was sacked as soon as The Sunday Times published its exposé, but his taped remarks lay dangerously on file.

Unfortunately for him, they are the clearest evidence so far on record that honours have routinely been traded for favours in contravention of the 1925 Honours (Prevention of Abuses) Act.

Waiting for Mr Smith on Thursday morning in an interview room in Redbridge police station was Det Supt Graham McNulty, the 35-year-old officer in day-to-day charge of the investigation.

It is his office that has been talking to the MP Angus MacNeil, whose complaint initially triggered the probe. But the SNP politician found the detective distinctly tight-lipped when he phoned for a progress report on Wednesday.

Mr MacNeil understood the reticence the following day as it emerged that Mr Smith had been arrested. "We thought something was up and now it seems we were right," he said.

But the manner of Mr Smith's arrest raises questions. Was it a stunt, intended to disprove speculation that the investigation was a sham? Or a shakedown, designed to flush out bigger players?

Certainly the arrest put under glaring limelight the previously obscure relationship between wealthy individuals and the city academy programme. Caught blinking near the centre of that web is the avuncular figure of Sir Cyril Taylor, a wealthy businessman who for decades has sought to lure entrepreneurs into funding state education.

The chairman of the SSAT, generally well regarded by those on all sides, was too canny to be entrapped by the undercover sting operation that did for Mr Smith, but nonetheless now finds himself under intense scrutiny. He has already been contacted by Met detectives by phone.

"We are happy to collaborate," Sir Cyril said. "We are supplying or have supplied everything that they have asked for."

But a trip to the police station is not his only concern. The phones in his office have been ringing off the hook with calls from anxious millionaires. "Our sponsors are worried about the bad publicity. They have been ringing up asking what is going on," Sir Cyril told The Independent on Sunday. "We have never made any links with honours."

The person at the very heart of the city academy programme is Mr Blair's former education adviser and now Schools minister, Lord Adonis. If promises were made, senior aides suggest, then they are likely to have been made by him.

"Cyril was important but the person really in charge was Andrew Adonis. It was Andrew who saw the big players, often in Downing Street," recalls one former official.

Another former aide of Mr Blair's involved in the raising of cash for schools is Baroness (Sally) Morgan, who was the Prime Minister's political secretary until her departure last year. Lady Morgan is now an adviser to a charity planning a £14m investment in seven city academies in London. Its chairman is the French hedge fund millionaire Arpad Busson, former partner of the model Elle Macpherson.

One colleague who had worked with Mr Smith for years, raising money for the academy scheme, said that the head teacher's boast that he could deliver honours had an element of wishful thinking about it. "He was a very good headmaster but I think he just got out of his depth," he said.

This nexus of money, philanthropy and political power is, say supporters of the scheme, already responsible for dramatically transforming the education of hundreds of thousands of schoolchildren.

Nevertheless, the potential abuse of the honours system that it has entailed, together with the secrecy with which it has been carried out, means that, even as they defend themselves, those responsible for its operation are distinctly nervous this weekend.

Far less public, but perhaps no less worrying from Mr Blair's point of view, have been the visits last week by two police officers to the Cabinet Office outpost that deals with the award of honours.

"The police turned up looking like a couple of night-club bouncers," said one startled civil servant.

"They weren't wearing uniforms but they were obviously police. They were big blokes. They were here to speak to two civil servants with oversight of the honours system."

When they left the Great Smith Street office, the policemen, part of the Metropolitan Police's specialist crime directorate, had in their possession a raft of confidential Whitehall documents relating to the Government's award of peerages.

Officers have also been in contact with officials from Labour, the Tories and the Liberal Democrats asking them about the existence of any "hidden" loans and the award of honours.

"They are looking at secret loans on the basis that if something has been declared there is less to likely to be anything dodgy than if they were secret," said one Westminster source who has spoken to the police. "They are looking at people who made these secret loans and were subsequently given peerages."

The investigators are paying particular attention to loans given to Labour after new, more stringent rules on the funding of political parties came into force in 2000.

In Labour's case the focus is on the donors who provided £14m of secret loans before the last election.

They include the Science minister, Lord Sainsbury, Labour's most generous benefactor, who lent £2m, and Rod Aldridge, executive chairman of Capita, who lent £1m.

Sir David Garrard, a property developer, Barry Townsley, a city broker, Dr Chai Patel, who founded the Priory Group, and Sir Gulam Noon, the curry magnate, are among Labour lenders nominated for honours who had their names withdrawn.

Not all Labour's secret lenders have been put on alert to expect a call from the Met - yet. Sir Gulam, currently out of the country, says he has heard from neither the police nor the Labour Party. "I have heard nothing," the Indian food entrepreneur told The Independent on Sunday. "I look forward to having a nice conversation," he added.

The main focus of the investigation is still expected to be the president of the SSAT, Lord Levy, who is also Mr Blair's chief fundraiser. The involvement of the diminutive pop impresario is fraying the nerves of some Downing Street officials.Not only is he directly connected to the Prime Minister, but he personally negotiated many of the loans.

As one Labour source put it: "If there are any buried bodies to be found, well, Levy is the man who knows where they are. He answered directly to Tony."

Officials at Downing Street have been frantically trying to find ways to shield the Prime Minister from the inquiry.

There has been talk of consulting lawyers, and PR men have been trying to devise a strategy to "close down" the story. But it is feared that even Jonathan Powell, the Prime Minister's chief of staff, could face police questioning.

As MPs return from their Easter break this week the pressure will intensify. The Prime Minister himself is to be grilled about the police inquiry at his weekly meeting with a committee of senior Labour MPs.

And MPs who sit on the Public Administration Committee are preparing to step up their own investigation and summon the key players, including Lord Levy, to give evidence.

To calm nerves, the Labour Party has sent out a memo to senior party figures, including Mr Blair, expressing optimism about the result of the police inquiry. "We are confident nothing will flow from that," it says.

That may be Labour's public line. However, the ramifications of the police inquiry, like the long arm of the law, have the potential to shake the very core of the Labour Party.

THE MEN FROM THE MET

Deputy Assistant Commissioner John Yates is the man with the future of Tony Blair and other prominent political figures in his hands.

The 47-year-old senior police officer is considered to be among one of the most reliable and trusted of the Metropolitan Police's senior officers, a reputation gained by his successful handling of a number of sensitive operations, including the UK policing response to the South-east Asian tsunami.

Hewas entrusted to take personal charge of the Met's copy of the confidential Independent Police Complaints Commission report into the shooting of Jean Charles de Menezes on the London Tube.

DAC Yates, who is married with two children and joined the Met in 1981, was also tasked with flying out to Brazil to apologise to the Menezes family for the death of their innocent son at the hands of Met firearms officers.

He led the police inquiry into the activities of Paul Burrell after it was alleged that the former butler to the Princess of Wales had stolen items belonging to her. The Old Bailey trial collapsed when the Queen remembered a conversation with Mr Burrell, in effect clearing him of any wrongdoing.

While DAC Yates is the official face of the honours inquiry, the daily handling of the investigation rests with Graham McNulty. The detective superintendent started his career in the south London borough of Wandsworth. For the past three years he has been investigating fraud as part of Scotland Yard's specialist crime directorate.

Sophie Goodchild