Police chiefs need to take into account the impact of large-scale operations on communities, the terror laws watchdog has said, after assessing the impact the investigation into the Manchester arena bombing had on the city’s Muslims.

Max Hill QC, the independent reviewer of terrorism legislation, discovered that a 35-year-old woman received compensation after she was wrongfully arrested in the days after the attack which killed 22 people and seriously injured 119 more.

The woman was resident at a Manchester address next door to a location that was significant to the investigation when she was arrested but it was established she was not involved. Her home was searched.

In his annual report on the operation of the terrorism acts in 2017, Hill said police had accepted the woman – known as Subject G – was “collateral damage: she was at the wrong place, at the wrong time”.

“This was a dynamic and urgent investigation involving multiple premises,” Hill said. “There were legitimate public safety issues; Jtac [Joint Terrorism Analysis Centre] had increased the national threat level to critical in the days after the attack.

“However, it is important to avoid the collateral damage Subject G experienced, and this has been accepted as a learning outcome for SIOs [senior investigating officers] and police teams in future.”

Salman Abedi, 22, walked into one of the entrances of the Manchester Arena on 22 May last year during an Ariana Grande concert and detonated a suicide bomb in a rucksack, killing himself. In the aftermath of the attack, Greater Manchester police arrested 23 people.

Hill said in his report that the police were to be commended for thoroughness and rigour in their investigation, known as Operation Manteline.

But he adds: “I do however make one further recommendation, which is that the police should consider and reflect upon the community impact of a large-scale investigation, centring as it did on particular areas of Manchester with a large Muslim population.

“Good community policing, as well as good counterterrorism policing, demands that real efforts are made to work within and with local communities, where many blameless residents will have been inconvenienced if not traumatised by the regular appearance of police search and arrest teams on their street or in their home.

“My observations … should be linked to a review of Manteline so far as it involved collateral damage so as to necessitate the payment of compensation to one arrested person, namely Subject G.”

Elsewhere in the report, Hill reviews the investigation into the London Bridge and Borough Market attacks on 3 June last year, in which three men armed with knives and wearing mock bomb-vests murdered eight people and injured 48 others. All three attackers – Khuram Butt, Rachid Redouane and Youssef Zaghba – were shot dead by officers.

Hill finds that 11 arrests at the home address of Butt – after an emergency call from a family member who suspected Butt’s involvement in the attack – were “difficult to justify”.

However, he adds: “There were multiple considerations here, including the unknown risk of a further attack in the aftermath of London Bridge, the question of whether any of those arrested may have had prior knowledge of the principal attack, and the extent of communication between individuals during the early hours immediately after the attack.”

Hill is stepping down from the role this month to become director of public prosecutions at the Crown Prosecution Service. He repeated concerns in his annual report that his successor is yet to be appointed.