A senior Hezbollah commander accused of orchestrating the killing of British and US citizens is at the centre of a diplomatic storm after a Baghdad court last week ordered his release.

US government officials have accused Ali Musa Daqduq, a Lebanese citizen, of involvement in a string of attacks, including the killing of five US soldiers on a base in the Iraqi city of Kerbala in 2007, while he was acting as the group's liaison to a shadowy Shia insurgent group, the League of Righteousness.

The group was also behind the kidnapping of five British contractors including Peter Moore – who was freed while his four bodyguards were murdered.

Daqduq, who had been held in US custody since his arrest, was handed over to the Iraqi government last year after the formal withdrawal of US combat troops after a promise from the government of Nouri al-Maliki that he would be tried. The two men Daqduq was arrested with in Basra – Iraqi brothers who led the group – have already been released as part of a British deal to secure the return of Moore and the remains of his guards.

Daqduq, who US officials say has been a member of Hezbollah for almost a quarter of a century, is alleged to have been sent to Iraq to create "special groups" within Shia militias. Despite the allegations that have been levelled against him, he has been held in custody in Iraq only on a single charge of failing to have a proper visa when he entered Iraq to fight coalition troops.

US officials claim he confessed to training Shia insurgents involved in lethal attacks while he was in their custody. Last week, however, an Iraqi court ruled that Daqduq could no longer be held on that charge, a decision which has infuriated American and British diplomats.

The news that Daqduq could be released came as US officials said they were seeking clarification from Baghdad. "We are very disappointed in the central criminal court's decision and believe that Daqduq should be held accountable for his crimes," one official said. "We are still awaiting additional information on the decision. The court addressed specific charges under Iraqi law in these proceedings and we have reached out to Iraqi officials to discuss the next steps in the judicial process. We will continue to work closely with our Iraqi counterparts on this process."

His release would be politically controversial in a US presidential election year, as the deal to permit his handover to Iraq and not remove him to Guantánamo Bay was made by the Obama administration. On Friday, Republican members of the US Senate judiciary committee released a letter accusing Obama of presiding over a major miscarriage of justice by negotiating the deal to hand over Daqduq to Iraqi custody.

"Now an Iraqi court has cleared Daqduq of any criminal charges under Iraqi law and – as we and many other observers had feared – [he] may be set free without being held to account for his crimes against the United States and its soldiers," they wrote.

Hezbollah sources in Beirut, who say that they count Maliki's government as an ally, insisted on Friday that Daqduq would not face any further charges. Sources in Baghdad suggested that he was still in Iraq and the order to release him was likely to be appealed against. One Hezbollah commander said: "You will see Hajj Radwan [a senior Hezbollah commander killed in a 2008 car bombing in Syria] give a press conference before you see Daqduq in Iraq again."

Daqduq was arrested in Iraq in July 2007 in the midst of an undeclared proxy conflict between American and coalition forces and members of the Iranian Revolutionary Guard's Al Quds force, which was actively destabilising parts of Iraq during that period.

Al Quds and other Iranian-backed groups were assisting Iraqi cleric Moqtada al-Sadr's Mahdi Army, of which the League of Righteousness was a faction, in conducting attacks on US and British forces.

On 20 January 2007, in Kerbala, a convoy of sports utility vehicles – commonly used by US forces – approached an American military checkpoint after easily passing several Iraqi army posts. The vehicles were cleared for entry because those inside carried apparently legitimate US military identification cards, were dressed in proper American military garb and spoke perfect English.

Upon entering the compound, they attacked US soldiers, killing one outright and abducting four. As they made their escape with coalition military forces in pursuit, they killed the four soldiers and dumped them by the side of the road. Intelligence experts and military analysts said the operation's professionalism far exceeded anything Iraqi insurgents were then capable of.

A month later a joint Delta Force and SAS operation in Basra captured Daqduq and the two brothers, Qais and Laith al-Khazali, who were thought to command the League of Righteousness and who were blamed for the Kerbala attack.

While Hezbollah sources denied that Daqduq was being run directly by the militant group while he was in Iraq, they suggested he had been effectively seconded to an Iranian Revolutionary Guard commander while he was operating in Iraq.