Mongolia declares diplomatic war on Britain over arrested spy

Lucrative contracts threatened as agent languishes in Wandsworth prison

Britain is embroiled in a damaging diplomatic row with Mongolia over the arrest of its most senior spy which is threatening to derail relations between the two countries and freeze British companies out of contracts worth millions of pounds.

Bat Khurts, who was the head of Mongolia's counter-terrorism agency, has languished in London's Wandsworth prison since September. He was detained on a European arrest warrant on allegations of kidnap after he arrived at Heathrow airport expecting to hold security talks with Whitehall officials.

Mr Khurts' lawyers claim the British authorities allowed him to travel to London knowing that he would be arrested on behalf of German prosecutors for the alleged illegal rendition of a Mongolian refugee. A court this week put off until 3 February a decision on whether to send Mr Khurts to Berlin for trial or accept claims that the intelligence official enjoys diplomatic immunity.

But while the judicial process grinds on, the political and commercial fallout from what Mr Khurts described in court as the "insult" of his arrest is deepening. A rapprochement between these two Cold War adversaries, who are now allies in Afghanistan, has been thrown into sharp reverse.

The Mongolian Prime Minister, Sukhbaataryn Batbold, abruptly cancelled a trip to Britain in November, a move which lawyers for Mr Khurts say was directly linked to his arrest. Meanwhile, Britain's ambassador to Ulan Bator, William Dickson, who is claimed by Mr Khurts to have enthusiastically offered to set up meetings in Whitehall, has been recalled to London for "operational reasons".

The ramifications of Mr Khurt's sojourn in HMP Wandsworth are profound for British companies, who are attempting to break into what is predicted will be the world's fastest-growing economy in the next five years. Mongolian GDP is expected to more than triple to $23bn (£15bn) by 2013.

The London Stock Exchange had been in a good position to benefit from Mongolia's boom, which is driven by moves to exploit the country's vast mineral wealth. It was at the head of a list of foreign investors asked to bid for the contract to build a new state-of-the-art bourse in Ulan Bator.

Housed in a bright pink former children's cinema, the existing Ulan Bator bourse last year grew by 187 per cent despite trading for just one hour daily. But an expected announcement that LSE will run the new exchange has not been made and the deal, along with others involving British companies, has been imperilled by the arrest of Mr Khurts.

A source within the Mongolian government said: "It is not inconceivable for these business contracts, which are currently under consideration by the Mongolian government, to be at risk following the grave discourtesy shown by the British."

The arrest of Mr Khurts, who is a key figure in Mongolia's National Security Council, which has the final decision on all major legislation in the country, has gone down extremely badly in Mongolia. Another source said: "It is like another country arresting the head of MI5 during a diplomatic visit. Were that to happen the British would, rightly, go absolutely ape shit."

All of which places the Government in a difficult situation. As one British businessman familiar with Mongolian officialdom put it: "The Mongolians consider that one of the most influential people in the country has been tricked into custody. The British on the other hand have to uphold the rule of law. The Germans are not going to be impressed if they now just let this guy go."

Mr Khurts and his legal advisers have not yet expressed a view on the allegations he faces. A former field agent, he is accused of being part of a snatch squad which kidnapped and drugged Damiran Enkhbat – a dissident wanted for the murder of a Mongolian government minister – in northern France in 2003. German prosecutors allege Mr Enkhbat was transported to Berlin in a car driven by Mr Khurts and then placed against his will on a flight to Ulan Bator.

But Foreign Office protests to the Mongolians that they must let the judicial process take its course ring hollow in Ulan Bator. Lawyers for Mr Khurts insist that he was "lured" to Britain with promises of high-level meetings with counter-terrorism officials only to be arrested.

Alun Jones QC told Westminster magistrates' court this week that the treatment meted out to Mr Khurts, who was travelling on a diplomatic passport, should serve as a warning to other nations sending diplomatic delegations to London. He said: "Countries in Asia and the Middle East ought to know that if they are sending senior civil servants to this country the Foreign Office might be planning to arrest them."

Behind the scenes, diplomats strongly deny the claims that they "entrapped" Mr Khurts, insisting that no meetings had been scheduled with British officials when he arrived. They are also working hard to try to rebuild their crumbling relations with Ulan Bator, insisting that Mr Batbold has only postponed his visit to London and that Mr Dickson's recall to London was unrelated to the row over Mr Khurts.

In a statement, the Foreign Office said: "The arrest in no way amounts to a diplomatic or political statement by the British government."