Details concerning the mounting financial crisis facing the Queen have been disclosed to The Independent after ministers agreed to hand over secret correspondence between Buckingham Palace and the Government.

The documents reveal that at the same time the Queen was requesting more public money to pay for the upkeep of her crumbling palaces she was allowing minor royals and courtiers to live in rent-free accommodation. They show that as early as 2004 Sir Alan Reid, the Keeper of the Privy Purse, had unsuccessfully put the case to the Department for Culture, Media and Sport (DCMS) for a substantial increase in the £15m a year public funding.

But by 2005, the papers reveal, there was mounting pressure from the Commons Public Accounts Committee for the Queen's aides to come clean about the extent of the grace-and-favour schemes being operated by the Palace. One letter shows that among the royals living rent-free in Kensington Palace and St James's Palace are the Duke and Duchess of Gloucester, the Duke and Duchess of Kent and Princess Alexandra.

The Surveyor of the Queen's Pictures and the Mistress of the Robes are two of six members of the Royal Household identified as not paying rent on their accommodation at the time.

Some of the most sensitive and embarrassing documents still remain under wraps while the Government goes to court to fight a substantial part of The Independent's Freedom of Information request.

Today's disclosure amounts to more than 100 letters, emails, memos and other documents.

The future funding of the Royal Family will be an issue facing whichever party wins the general election. Under a constitutional arrangement from 1991, the Civil List, which pays the Queen to perform her duties as head of state, must be renegotiated by the end of the year. At the moment it is an annual payment of £7.9m and the Palace is pressing hard for it to be increased.

Secret memos also show how the Palace planned to go ahead with refurbishing and renting Princess Diana's apartment at Kensington Palace after it had lain empty since her death in 1997.

In an email on 28 June 2005 the Palace informed the DCMS that the Royal Household intended to rent out Diana's rooms, anonymously known as Apartment 8-9. Having previously complained that public funds were insufficient to refurbish the rooms, the royal courtier wrote: "We have now decided that Apartment 8 will play an important role for temporary office accommodation."

But the Government was concerned about the public reaction to this re-use of Diana's apartment after it had remained empty for so long: "Apartment 8 is, of course, more difficult and I must be guided by you on how much we can say," said the DCMS official. "My view is that we should be as open as possible on the difficulties in finding an economic use for the apartment. This is an issue which is likely to attract attention and comment."

It later emerged that Buckingham Palace had rented the apartment to Prince Charles's charities.

A series of emails between the Royal Household and the DCMS also illustrate the lengths to which the Queen has gone to cut her bills.

In September 2005 the Queen's advisers complained to the Government that the "commercial market price for utilities has become untenable with price rises of over 50 per cent". They suggest a switch to a wholesale provider of gas and electricity and plump for Inenco which also serves the Prison Service and Channel 4.

The switch is approved by the DCMS officials who accept that the Queen has been "hard hit" by the cost of energy. But if the Royal Household had acted sooner Palace documents show that the Queen would have made a saving of £142,000 between 2004 and 2006.

Other documents reflect wrangles between the Palace and the Government over financing of the occupied palaces.

In October 2004 a senior official at the DCMS wrote to Sir Alan Reid taking issue with him over who has the rightful claim over the £2.5m proceeds from the sale of land from the Royal Garden Hotel in Kensingtion.

The official wrote: "We agreed that the receipt of £2.5m could affect any increased allocation which the Secretary of State is able to give to the Royal Household as result of the Spending Review. I have to say that the settlement is very tight and Ministers are not confident of being able to offer increased funding in all areas given the competing demands of the relatively small increase in the DCMS's budget."

He later adds: "That makes it more important to agree how we handle the £2.5m receipt. I cannot concede that it automatically belongs to the Royal Household. The receipts from the hereditary lands are surrendered to the Consolidated Fund [money held in the Government's bank account]. I hope we can come to an agreement on apportioning the receipt."

In further documents it transpires that the Treasury and DCMS have rejected requests for an increase to the grant-in-aid, taxpayers' money which finances the upkeep of the occupied palace. Today Royal aides say the backlog of property repairs stands at £32m which will rise to £40m in the next decade, prompting fears of a future public funding crisis.

A mounting financial crisis: Spiralling costs

The funding of the Royal Family is a complex formula comprising government grants and Civil List payments agreed by Parliament.

Much of what is perceived to be part of the Queen's fortune is not hers at all, but held in trust by her for the nation. This includes the Crown Jewels, Titians, Caravaggios, and many other priceless items.

In the low-inflation 1990s, however, the Queen was able to put some £35m to one side from the Civil List and it was then agreed that her payment would be frozen.

Over the past decade, Civil List expenditure has spiralled, meaning that she has been forced to take more money out of that fund each year. Assuming the current pattern continues, the fund will be wiped out by the time of her Diamond Jubilee in 2012.

She is still believed, however, to possess private wealth last estimated to be more than £90m.

Soon the debate over the escalating costs of the Royal Family will come to a head as the Queen is forced to go cap-in-hand to ministers for more cash to protect her constitutional position as head of state.

Palace aides have told Whitehall officials they need the extra money to offset the expense of maintaining the Royal Estate of palaces and to pay for increased staffing costs. But in the current financial climate any increase in the annual £35m state subsidy is politically sensitive.

Both sides are now engaged in a public relations battle as time runs out on negotiations that must settle the matter by the end of next year when the present deal on the Civil List expires. A second deal on the £15m paid in grants for the upkeep of the palaces is due to be finalised in 2011.

Royal aides contend the Queen's accommodation is in a parlous state and point to 2007, when Princess Anne had a narrow escape after some loose masonry was dislodged from the roof on Buckingham Palace. Another piece fell last year, missing a police officer who was on duty.

Royal expenditure: The disclosures

Land at the Royal Garden Hotel

An email and letter exchange reveals a tussle over who has control of £2.5m gained from the sale of Kensington Palace land in 2004. Ministers say it belongs to the state, while Buckingham Palace maintains it belongs to the Queen.

Overspends

There was a £40,000 overspend in the refurbishment of the kitchen and coffee room of Windsor Castle. The kitchen is used to prepare hot drinks for the Queen and her household. The workmen uncovered voids under the floors which might provide "rat runs". The refurbishment of York House (St James's Palace) led to an overspend of £99,000.

Hard times

In September 2005 the Queen's advisers complained that the "commercial market price for utilities has become untenable with price rises of more than 50 per cent". They suggested a switch to a wholesale provider of gas and electricity, to Inenco, which also serves the Prison Service and Channel 4. The switch is approved by DCMS officials noting that the new contract will "undercut" traditional fuel companies by 6-8 per cent. If they had thought of it two years earlier, they could have saved £144,000.

Diana's apartment

Secret memos shine a light on plans to refurbish and rent out Princess Diana's apartment at Kensington Palace after it had laid empty since her death in 1997. After the work was completed, Apartment 8, as it is refered to by Palace aides, was controversially leased to Prince Charles's charities. The memos warn that plans for the future use of these apartments are "more difficult and an issue likely to attract attention and comment".

Grace and favour living