The Iraqi government is in danger of being brought down by the wholesale smuggling of the nation's oil and other forms of corruption that together represent a "second insurgency", according to a senior US official. Stuart Bowen, who has been in charge of auditing Iraq's faltering reconstruction since 2004, said corruption had reached such levels that it threatened the survival of the state.

"There is a huge smuggling problem. It is the No 1 issue," Mr Bowen told the Guardian. The pipelines that are meant to take the oil north have been blown up, so the only way to export it is by road. "That leaves it vulnerable to smuggling," he said, as truckers sell their cargoes on the black market.

Mr Bowen, the Special Inspector General for Iraq Reconstruction (Sigir), cites Iraqi figures showing that the "virtual pandemic" of corruption costs the country $4bn (£2.02bn) a year, and some of that money goes straight to the Iraqi government's enemies. A US government report has concluded that oil smuggling abetted by corrupt Iraqi officials is netting insurgents $100m a year, helping to make them financially self-sustaining.

"Corruption is the second insurgency, and I use that metaphor to underline the seriousness of this issue," Mr Bowen said. "The deputy prime minister, Barham Saleh, told Sigir this summer that it threatens the state. That speaks for itself."

The Bush administration's strategy in Iraq hinges on the survival of the government run by Nuri al-Maliki, despite US reservations about the prime minister's readiness or ability to confront extremists in his own Shia community.

But Mr Bowen's office has found that the insurgents and militias have also been abetted by US incompetence. A recent audit by his inspectors found that more than 14,000 guns paid for out of US reconstruction funds for Iraqi government use could not be accounted for. Many could be in the hands of insurgents or sectarian death squads, but it will be almost impossible to prove because when the US military handed out the guns it noted the serial numbers of only about 10,000 out of a total of 370,000 US-funded weapons, contrary to defence department regulations.

Jim Mitchell, a Sigir spokesman, said: "The practical effect is that when a weapons cache is found you're deprived of the intelligence of knowing if they were US-provided, which might allow you to follow the trail to the bad guys."

Mr Bowen's inspectors are among the few US civilian officials who still venture beyond the fortified bounds of the Green Zone in Baghdad into the rest of Iraq, to see how $18bn of American taxpayers' money is being spent. Much of the money has been wasted. Sigir officials have referred 25 cases of fraud to the justice department for criminal investigation, four of which have led to convictions, and about 90 more are under investigation.

A culture of waste, incompetence and fraud may be one legacy the occupiers have passed on to Iraq's new rulers more or less intact. Mr Bowen's office found that nearly $9bn in Iraqi oil revenues could not be accounted for. The cash was flown into the country in shrink-wrapped bundles on military transport planes and handed over by the ton to Iraqi ministries by the Coalition Provisional Authority (CPA) run by Paul Bremer, a veteran diplomat. The money was meant to demonstrate the invaders' good intentions and boost the Iraqi economy, which Mr Bremer later insisted had been "dead in the water". But it also fuelled a cycle of corruption left over from Saddam Hussein's rule.

"We know it got to the Iraqis, but we don't know how it was used," Mr Bowen later told Congress.

In the Hillah region a defence department contract employee and two lieutenant colonels were found to have steered $8m in contracts to a US contractor in return for bribes. The Pentagon contract employee, Robert Stein, pleaded guilty earlier this year, admitting he and his co-conspirators received more than $1m in cash, help with laundering the funds, jewellery, cars and sex with prostitutes. Stein also admitted that they simply stole $2m from the construction fund, accounting for the money with receipts from fictitious construction companies.

Hillah just happened to be the district Mr Bowen's inspectors examined in depth. It is still far from clear how much reconstruction money has gone missing around the whole country.

A potentially far more serious problem has been the way the US government decided to give out reconstruction contracts. It split the economy into sectors and shared them out among nine big US corporations. In most cases the contracts were distributed without competition and on a cost-plus basis. In other words the contractors were guaranteed a profit margin calculated as a percentage of their costs, so the higher the costs, the higher the profits. In the rush to get work started the contracts were signed early in 2004. In many cases work did not get under way until the year was nearly over. In the months between, the contractors racked up huge bills on wages, hotel bills and restaurants.

According to a Sigir review published in October, Kellogg, Brown and Root (a subsidiary of Halliburton, Vice President Dick Cheney's former company) was awarded an oil industry repair contract in February 2004 but "direct project activity" did not begin until November 19. In that time KBR's overhead costs were nearly $53m. In fact more than half the company's $300m project costs from 2004-06 went on overheads, the audit found.

Iraq also represented a grey zone beyond the reach of the US civil courts. KBR was found to have overcharged the US military about $60m for fuel deliveries, but that did not stop it winning more government contracts.

A California company, Parsons, had its contract terminated this year after it was found to have finished only six of more than 140 primary healthcare centres it was supposed to build, after two years work and $500m spent. However, the contract was ended "for convenience", meaning Parsons was paid in full. In a police college Parsons built for $75m in Baghdad the plumbing was so bad that urine and excrement rained down from the toilets on to the police cadets. Parsons left a sub-contractor to do repairs but in general there is little punitive action that can be taken for shoddy work.

Part of the reason big US contractors have been able to get away with so much is that there has been limited proper supervision. CPA employees were picked not for their financial expertise but for their political loyalty.

Mr Bowen would have passed the test. He campaigned for George Bush in Texas and was one of the small army of Republican lawyers called in to Florida in 2000 to oversee the vote recounts on Mr Bush's behalf. When he started the job in March 2004 few expected he would do anything to embarrass the administration.

However, Mr Bowen has emerged as the scourge of the big corporations who are among the Republican party's biggest donors. Earlier this year a clause extending his mandate was stripped from a military spending bill just before a vote. Sigir, however, seems to have been saved by the Democratic victory in last month's elections.

Mr Bowen bristles at the suggestion that Mr Bush might have had a hand in the attempt to close his office. "I'm doing exactly what the president expects me to do," he said.