Tony Blair's government broke the law when it abandoned a fraud investigation into a multibillion-pound arms deal between BAE Systems and Saudi Arabia, the High Court ruled yesterday.

Two senior judges condemned the Government's "abject" surrender to a "blatant" threat when the Serious Fraud Office (SFO) halted its inquiry into allegations that BAE had made secret payments to Saudi officials in order to secure a series of massive contracts. BAE has always denied any wrongdoing.

Calling on Gordon Brown to hold a public inquiry into the affair, jubilant campaigners demanded the fraud investigation into the £50bn Al-Yamamah deal to sell Tornado and Hawk jets to the Saudis be restarted.

Mr Blair faced controversy in December 2006 when Lord Goldsmith, the Attorney General, announced the investigation had been dropped. Mr Blair warned at the time that threats had been received which indicated that continuing the inquiry would put British lives at risk.

But yesterday, Lord Justice Moses and Mr Justice Sullivan said that the SFO director, Robert Wardle, had failed to stand up to threats from the Saudis.

They said: "The director was required to satisfy the court that all that could reasonably be done had been done to resist the threat. He has failed to do so."

The judgment added: "No one, whether within this country or outside, is entitled to interfere with the course of our justice. It is the failure of government and the defendant to bear that essential principle in mind that justifies the intervention of this court."

The judges added: "On 11 December 2006, the Prime Minister said this was the clearest case for intervention in the public interest he had seen. We agree."

Disagreeing with the Government's argument that the SFO was entitled to "surrender" to the threat, the judges said: "So bleak a picture of the impotence of the law invites at least dismay, if not outrage." They were scathing about the SFO's line that the decision to halt the inquiry was taken independently of the Government. "The more the defendant stresses that he reached a conclusion free from pressure imposed by the UK Government, the more he demonstrates the inconsistency in submitting to pressure applied by the government of a foreign state," the judges ruled.

The no-holds-barred judgment sparked joy last night among the arms trade campaigners who had taken the case to the High Court.

Demanding that the SFO restart its investigation, Symon Hill, of the Campaign Against the Arms Trade which brought the action with the pressure group Corner House, said: "We hope the SFO will reopen the inquiry and we call on Gordon Brown and his government not to stand in the way."

He added: "We are delighted. This judgment brings Britain a step closer to the day when BAE is no longer calling the shots. It has been clear from the start that the dropping of the investigation was about neither national security nor jobs. It was due to the influence of BAE and Saudi princes over the UK Government."