• Patrick McLoughlin says fault lies 'only and squarely with DfT' • Transport secretary launches urgent review into bid process • Virgin believes hardcore element at DfT 'just don't like us' • Miliband calls taxpayers' £40m compensation bill a 'disgrace' • Competition for franchise will be rerun

Three government officials at the heart of the abandoned west coast mainline franchise competition have been suspended after the transport secretary launched an urgent review into how the award of Britain's most lucrative rail service ended in fiasco.

Patrick McLoughlin said he was angry and that the fault lay "only and squarely within the Department for Transport". The shock move looks set to revive the apparently doomed Virgin Trains after the government admitted to "significant flaws" in the franchise process that was won by FirstGroup.

Taxpayers now face paying compensation of £40m to the original bidders – something the Labour leader, Ed Miliband, called a disgrace.

Virgin and McLoughlin will be holding talks to discuss options later on Wednesday, with the tender process likely to be rerun. Until Tuesday the transport secretary had, like his predecessor Justine Greening, defended the "robust" process, and he was set to invite the state-owned Directly Operated Railways (DOR) to run the service when the current franchise expires on 9 December had Virgin's legal proceedings delayed the new contract with FirstGroup.

The developments have hardened Virgin's view that a "hardcore" at the department "just don't like us", as an insider put it. Its owner, Sir Richard Branson, had offered to run the service "for free" while the row was resolved but that offer is now likely to be moderated. Staff at Virgin believe the DOR option was "to rub our noses in it" and the picture has now changed.

Branson told BBC Radio 4's The World at One: "The system has been flawed for some time. Hopefully, as a result of this fiasco, a new system can be put in place that will be good for the passengers, good for the taxpayer and good for the operators."

He cautioned the government against trying to take over the line itself. "If they can't run the process they are going to have even more difficulty running a railway. I would suggest that would not be a good idea," he said.

The officials have not been named, but apparently incorrectly calculated the risk involved in the winning bid. A DfT spokesman said: "Three officials involved in the west coast franchise competition were today suspended by the permanent secretary while the full facts are established. No further details will be issued at this time about the suspensions."

Other franchises due to be settled in the next two years will be put on hold in a move that raises raise questions over the whole rail system, with unions and Labour considering calling for renationalisation.

Miliband said the episode was "another hopeless shambolic piece of incompetence" from the government and warned that the public would pay the price. "People want competent government and we're not getting it in transport obviously," he said.

And speaking at the start of a question-and-answer session with delegates at the Labour party conference, Miliband said: "It is a disgrace that it is going to cost £40m and perhaps more of taxpayers' money because they have bungled this franchise." He said the government needed to "get a grip" and criticised the way that Department for Transport staff were being blamed.

The DfT discovered the flaws as it was preparing to contest the judicial review that Branson's firm sought in the high court after losing the franchise to FirstGroup on 15 August.

The Virgin chairman said: "They have basically acknowledged that what we had been saying is correct. The same procedures were not followed and 'deeply regrettable and completely unacceptable mistakes' were made by the department.

"We also appreciate the DfT publicly acknowledging these errors, and are hopeful they will now accept that Virgin Trains should carry on running the west coast mainline and ensure that passengers continue receiving our team's award-winning service."

A spokesman for FirstGroup, which had been set to run the franchise although contracts had never been signed, said: "We are extremely disappointed to learn this news and await the outcome of the DfT's inquiries. The DfT have made it clear to us that we are in no way at fault, having followed the due process correctly. We submitted a strong bid, in good faith and in strict accordance with the DfT's terms.

"Our bid would have delivered a better deal for west coast passengers, the taxpayer and an appropriate return for shareholders."

Shares in FirstGroup tumbled almost 20% in early trading, down 47p at 197p.

FirstGroup's winning bid, with payments heavily loaded towards the back end of the 13-year franchise, offered premiums far in excess of the bond it was offering as security. Virgin had described the winning bid as "preposterous" and a recipe for bankruptcy. The other two shortlisted bidders, Abellio and Keolis, backed by the Dutch and French state railways, bid far less even than Virgin.

An investigation will be conducted by the department. However, legal advice is being sought on whether Virgin could continue to run the service after 9 December, indicating that the DfT could be set for a humiliating climbdown after rebuffing Branson.

McLoughlin told the BBC's Today programme that the mistakes were "deeply regrettable and unacceptable and I'm very angry about what happened".

He said: "Some of the points Richard Branson made were found to be correct, but there were things that were more wide ranging … That's why I took the decision last night to go back to the drawing board."

McLoughlin said passengers would continue to be served by the same trains and frontline staff.

Independent reviews

The transport secretary has ordered two independent reviews to be undertaken urgently: the first into what went wrong with the west coast competition and the lessons to be learned, and the second into the wider DfT rail franchise programme.

Meanwhile, he has frozen all other outstanding franchise competitions – Great Western, Essex Thameside and Thameslink – pending the independent reviews, which the DfT hopes will ensure future competitions are robust.

McLoughlin said: "I have had to cancel the competition for the running of the west coast franchise because of deeply regrettable and completely unacceptable mistakes made by my department in the way it managed the process.

"A detailed examination by my officials into what happened has revealed these flaws and means it is no longer possible to award a new franchise on the basis of the competition that was held.

"I have ordered two independent reviews to look urgently and thoroughly into the matter so that we know what exactly happened and how we can make sure our rail franchise programme is fit for purpose."

He added: "West coast passengers can rest assured that while we seek urgently to resolve the future arrangements the trains that run now will continue to run, with the same drivers, the same staff and timetables as planned. The tickets that people have booked will continue to be valid and passengers will be able to make their journeys as planned."

The most senior civil servant at the department, Philip Rutnam, said: "The errors exposed by our investigation are deeply concerning. They show a lack of good process and a lack of proper quality assurance.

"I am determined to identify exactly what went wrong and why, and to put these things right so that we never find ourselves in this position again."

The first independent review will be overseen by Centrica's chief executive, Sam Laidlaw, and the former PricewaterhouseCoopers strategy chairman Ed Smith to work out what went wrong with the award of the franchise. It is expected to report by the end of October.

The second review, to be undertaken by the Eurostar chairman, Richard Brown, will examine the wider rail franchising programme and look in detail at whether changes are needed to the way risk is assessed and to the bidding and evaluation processes, and at how to get the other franchise competitions back on track.

The DfT said it found evidence of significant flaws as its officials were gathering evidence in preparation for legal proceedings.

These flaws stem from the way the level of risk in the bids was evaluated. Mistakes were made in the way in which inflation and passenger numbers were taken into account, and how much money bidders were then asked to guarantee as a result.

The department said it could not be confident that these flaws would not have changed the outcome of the competition or that any of the four bidders would not have chosen to submit different offers.

The four bidding companies – First, Virgin, Keolis-SNCF and Abellio – will all be compensated, and have been assured a fresh competition will be started. The costs will be around £40m – £14m to Virgin alone.

McLoughlin said he did not anticipate having to reimburse transport groups bidding in the other, currently frozen, franchise processes.

Meanwhile, the political fallout will see not just the franchise but the government and the privatised rail system under scrutiny.

'Fiasco'

The shadow transport secretary, Maria Eagle, said it was a "fiasco" that had "again exposed the shambolic incompetence of this Tory-led government".

She said: "Only last week the transport secretary repeated his claim that the process was conducted properly and he would hand over the franchise to First on time, despite all the concerns that had been raised. The government's belated admission that it ran a flawed tendering process will come as a surprise to no one.

"The transport secretary must now reveal the full details of what went wrong and come clean on the full cost to taxpayers of this shambles."

She added that Labour would support the transfer of the west coast service to DOR, the DfT's rail company, and called for the government to abandon the planned privatisation of the east coast line.

Louise Ellman, the chair of the transport select committee, said it would be recalling the secretary of state to answer more questions after he assured MPs at a hearing last month of the fairness of the process.

The leader of the RMT union, Bob Crow, said: "The whole sorry and expensive shambles of rail privatisation has been dragged into the spotlight this morning and instead of re-running this expensive circus, the west coast route should be renationalised on a permanent basis."

• This article was corrected on 3 October 2012 because the original said shares in FirstGroup were at £19.07 in early trading on Wednesday, when it should have said 197p.