Prime Minister John Key says he is "quite shocked" at the possibility government spies acted unlawfully in the Kim Dotcom case.

However, the internet tycoon's US lawyer says it's too early to say if an investigation into the allegations will halt his case against extradition to the US, where Dotcom is wanted on anti-piracy charges.

Key has ordered an inquiry over interceptions in the Dotcom case by the Government Communications Security Bureau (GCSB) while assisting police to find people subject to arrest warrants.

At a post-Cabinet press conference, Key this afternoon said he referred the matter to the Inspector General last Monday - the same day he learned of the breach. Key said he was "quite shocked", but had confidence in the bureau. He told reporters he had been advised not to make a statement until filing papers with the court.

Key said he believed the incident was an isolated error and did not think it was because New Zealand authorities wanted to "curry favour" with the US.

"On the explanation I have at the moment, it was a mistake, an error, but that's now subject to an inquiry."

He added he was not asked to sign an intercept warrant, "nor was I briefed on the operation in question".

Speaking from the US, Ira Rothken said Dotcom's legal team will await the outcome of the inquiry and did not want to ''pre-judge'' it.



The investigation will deal with ''whether or not the intelligence agency broke the law by essentially spying on folks domestically'', Rothken said.



''It all depends on what the results are and what the prime minister does ... obviously we'd be interested to know if the United States was involved...we'll await the results."



He added: ''I think any time the prime minister orders an inquiry of the intelligence services potentially spying on residents domestically there should be a healthy concern.''



He was unable to say what communications were intercepted.



Dotcom was aware of the statement from Key, he said. ''He very much looks forward to the results of the inquiry, whether there has been a intrusion of domestic privacy.''

The inquiry's announcement comes just two days before Dotcom's case is again due in the High Court in Auckland.



Justice Helen Winkelmann has directed a hearing be called on Wednesday to discuss the search warrants issued for the January raids on Dotcom's Auckland mansion.



Fairfax Media understands the memo filed by the Crown about the GCSB relates to that hearing - not to either the extradition case or the disclosure hearing held in the Court of Appeal last week.



The search warrants issued for the raids were earlier ruled illegal by Justice Winkelmann. Dotcom's lawyers are now seeking a remedy for the situation. This has so far involved discussing the way the raids played out in minute detail at a two-day hearing last month.

The Crown is refusing to release the memo, saying the request must go through the court. Applications to the court can be lengthy, as all parties must have the opportunity to respond before the judge makes a decision on a document's release.

Labour leader David Shearer says Key must come clean on what he knew about illegal spying by GCSB.



He said it was a ''shocking breach'' of strict laws on snooping.



And he questioned how much Key knew about the raid. Key says he first heard of Dotcom on the day before police arrested the internet millionaire at his Coatesville estate.



Shearer said Key is responsible for signing off all intercept warrants by GCSB. ''While it's been revealed that 'some' bugging was done illegally, it is not credible to think that other monitoring by the agency was not signed by the Prime Minister before the raid was carried out.''

Green Party co-leader Russel Norman said a number of New Zealand agencies have ''bent over backwards'' to assist the US in prosecuting Dotcom.

"Government agencies should not, however, break New Zealand's laws to assist another country.



"The Kim Dotcom case doesn't appear to constitute a threat to New Zealand's national security, so it is hard to understand why the GCSB considered it should be involved at all.''



He called on the Government to make public the investigation findings.

Auckland University associate law professor Bill Hodge said evidence used in the extradition case would come from the US, not from New Zealand agencies. The revelations therefore might not have any bearing on the hearing.



He said he ''puzzled'' by the development.



The Prime Minister must sign off on any warrants for eavesdropping - and because Key has said he only learned of Dotcom on the day before the raid, it is unlikely there was a warrant. He said former prime minister Helen Clark signed off on two or three of the warrants a year, but they were not common.

Following news of the inquiry, Dotcom took to Twitter.

He wrote: "I'm now a real life James Bond villain in a real life political copyright thriller scripted by Hollywood and the White House.''

Dotcom was arrested in January in an FBI-led sting. His case is due to be heard next March.



However, it has hit a number of hurdles. High Court judge Helen Winkelmann has ruled search warrants used were invalid and the sending of his cloned computers to the United States illegal.



And district court judge David Harvey ruled Dotcom should be able to access details gathered by the FBI.



But the judge was forced to step aside after calling the US ''the enemy'' at an internet conference in July.