Tony Blair "very much exaggerated" Iran's role in supporting al-Qaida insurgents in their attacks on British and US forces in Iraq, Britain's ambassador in Tehran at the time of the invasion said today.

Sir Richard Dalton told the Chilcot inquiry that London and Washington misread the intentions of the Iranian regime, believing it would inevitably be hostile to their mission in Iraq when in fact Tehran wanted them to succeed in installing a stable government in Baghdad.

Dalton – Britain's ambassador to Iran from 2003 to 2006 – said Blair made "a series of very bad decisions" about the legality of the 2003 invasion. He described the description by President George Bush's of Iran as part of an "axis of evil" as a "monstrous error".

As international pressure continues to increase over Tehran's alleged efforts to acquire nuclear weapons, Dalton also warned that military action against Iran would be illegal unless there was evidence it posed an "imminent and real" threat to another country.

In evidence he gave to the Chilcot inquiry in January, Blair dwelt on the role of Iran and al-Qaida in destabilising Iraq and making the task of rebuilding the country more difficult after the overthrow of Saddam Hussein.

"What nobody foresaw was that Iran would actually end up supporting al-Qaida," Blair said. "What happened in the end was that they did because they both had a common interest in destabilising the country, and for Iran I think the reason they were interested in destabilising Iraq was because they worried about having a functioning majority Shia country with a democracy on their doorstep."

Dalton, however, told the inquiry today: "From what I saw of his evidence, I thought he very much exaggerated this factor." Iranian help to al-Qaida was limited to permitting fighters to pass across its territory from Pakistan and Afghanistan, he said. Tehran had no interest in promoting "anarchy" in Iraq, but wanted an inclusive Iraqi-run government capable of acting as a source of stability in the region.

He added: "I did believe at the time – particularly in 2003 – there was a misreading of Iran as inevitably hostile to the success of the coalition mission.

Iran wanted to foment enough disorder in Iraq to "make sure the coalition felt some pain and therefore didn't dig in for a long stay", but its interference, including support for Shia militia in Iraq, was not as critical to the US-led mission as the insurgency led by former Ba'athists.

"Their objective was never to destabilise Iraq to the point at which the whole enterprise would fail," Dalton said. "They feared anarchy and they feared that if the handover to Iraqi politicians was to fail completely, that would be the worst possible situation for Iran, because that would allow the Americans an excuse to stay very much longer."

Washington's refusal to listen to legitimate Iranian concerns that the west was "messing in their neighbourhood" led to a damaging downward spiral in relations with Tehran, Dalton told the inquiry.

"I also felt at the time of Mr Blair's testimony to you that he was seeking to cast a retrospectively benign light on a series of very bad decisions taken about the legality of an attack on Iraq by saying it was not only right to do it, but we might have to do it again," he added.

"I felt strongly then and I do now that a military adventure against Iran ... would be illegal in the absence of an imminent and real threat to any country from Iran. No such nuclear threat exists at present."