Iraqi officials and relatives of 17 Iraqis who were killed in a crowded Baghdad square in September 2007 in an allegedly unprovoked shooting spree by Blackwater private security guards reacted with fury today to the decision by a US federal judge to dismiss all charges against five of the guards.

A spokesman for the Iraqi government said the collapse of the case in the US courts would lead to an intensified criminal prosecution of Blackwater through the Iraqi legal system. Ali al-Dabbagh said the criminal suit was already well advanced against the firm, which would not be allowed to restart its private military work in the country.

"The government will monitor proceedings against Blackwater in Iraqi courts to prosecute the company and will preserve the rights of Iraqi citizens, of the victims and their families affected by this crime," he said.

Abdul Wahab Abdul Kader, 35, who was shot in the arm, said he was bitterly disappointed. ""I call for the government to stop all foreign security companies working in Iraq. Their work here has been full of dangers for us and has caused real peril."

Haitham Ahmed, whose wife and son were killed, said the dismissal of the case cast doubt on the integrity of the US justice system. He told Associated Press: "The whole thing has been a farce. The rights of our victims and the rights of the innocent people should not be wasted."

The shooting, on 16 September 2007, caused outrage around the world and strained relations between the US and Iraq. A series of congressional hearings was held, and militant groups leapt on the bloodshed as evidence of US brutality.

Blackwater was expelled from most of its key contracts in Iraq and forced into a major damage-limitation exercise that included rebranding itself Xe Ltd.

The incident began when a heavily armed Blackwater convoy moved into a busy square in Baghdad, after breaking an order to stay in the US-controlled green zone of the city, prosecutors allege. The five were accused of opening fire with automatic weapons and grenade launchers on unarmed civilians, killing children, women and men attempting to flee in their cars. One victim was alleged to have been shot in the chest while standing with his hands in the air. Defence lawyers said they had been responding to an earlier car bombing and were attacked by Iraqis they believed to be enemy insurgents.

In his 90-page ruling, Judge Ricardo Urbina made no comment on the legality or otherwise of the shooting. He dismissed the case on the grounds that the five had had their constitutional rights violated by the way confession statements they had made had been used by the prosecution.

The statements were made when the men were under threat of losing their jobs if they did not cooperate with investigators. The US government had promised that their statements would not be used against them in a criminal case.

Urbina said that despite this immunity deal, the statements had been used, thus tainting the investigation. He said the government's case had been "contradictory, unbelievable and lacking in credibility".

If convicted, the five guards, all of whom were former US military personnel, would have faced a 30-year sentence.

"It feels like the weight of the world has been lifted off his shoulders," said Steven McCool, a lawyer for one of the five, Donald Ball. "Here's a guy that's a decorated war hero who we maintain should never have been charged in the first place."

The legal fate of a sixth guard, Jeremy Ridgeway, is now unclear. He pleaded guilty to killing one Iraqi and wounding another, and gave evidence against his five former Blackwater colleagues.

Xe said that the dismissal of the case meant "we can move forward and continue to assist the US in its mission to help the people of Iraq and Afghanistan find a peaceful, democratic future".

However, relatives have lodged civil charges against the five in the Virginian courts. Tareq Harb, an Iraqi lawyer, said of the US federal court: "They did not call local witnesses, or victims, or officials who responded to the scene. The guards were protected under Bremer's law [US administrator in Iraq before 2004]. There was no due process, or natural justice."