During stormy scenes in the Commons, Mr Blair said that while it was the SFO's decision, he was "perfectly happy to take responsibility" for it.

Pursuing the investigation would have led to a "complete wreckage" of Britain's relationship with Saudi Arabia - a country which provides crucial intelligence in the war against terror, he said.

To think otherwise is to be living in "cloud cuckooland," he added.

The Prime Minister faced questions from MPs for the first time since a series of damning allegations were made earlier this week in an investigation by BBC's Panorama programme.

It has been claimed that up to £1bn of BAE money has been paid to Saudi Arabia's former US ambassador Prince Bandar bin Sultan as part of the Al Yamamah arms deal.

The payments were allegedly authorised by the Ministry of Defence.

The government sparked huge controversy when Attorney General Lord Goldsmith announced that the SFO had dropped its investigation into the £46bn contract.

Liberal Democrat leader Sir Menzies Campbell taunted Mr Blair by asking what had happened to New Labour's "foreign policy with an ethical dimension".

Mr Blair replied: "The criticism of the Attorney General in relation to this is completely and totally unfair and wrong.

"If he wants to blame anyone for this he can blame me.

"I am perfectly happy to take responsibility for it.

"These allegations are strenuously denied by the Saudi royal family."

He said the SFO investigation would have resulted in the "complete wreckage of a relationship which is of fundamental importance to the security of this country, to the state of the Middle East and to our relationship with countries in the Middle East.

"That is why I took the decision - I didn't regret it then and I don't regret it now."

The continued controversy surrounding the BAE dealings with Saudi Arabia has fuelled fears among the 10,000 Lancashire workers employed by the defence giant in Warton and Samlesbury, near Preston.

Mr Blair praised the Al Yamamah deal, first signed under Margaret Thatcher's Tory government for the employment it has created.

He said: "I am delighted that we managed to win that contract which protects thousands upon thousands of jobs within this country."

It was announced on Monday that the former Lord Chief Justice of England and Wales, Lord Woolf, is to chair a committee to look at how BAE does business.