A Catholic priest directed devastating IRA car bomb attacks in the Northern Irish village of Claudy in 1972 and his role was covered up by senior police officers, government ministers and the Catholic hierarchy, an official investigation has revealed.

The government said today it was "profoundly sorry" about the cover-up, while Northern Ireland's Catholic church said it accepted the findings, calling them "shocking".

Nine people were killed and more than 30 were injured when three vehicles exploded on the main street without warning on 31 July. It was one of the worst atrocities of the bloodiest year of the Troubles.

Three of the dead caught up in the mid-morning blast were children. No one was ever charged with the killings, and the IRA at the time denied responsibility.

The long-awaited report by the police ombudsman for Northern Ireland, published today, confirms suspicions that Father James Chesney, a priest in the nearby village of Bellaghy, was directly involved in the IRA operation, and suggests his involvement was even greater than previously assumed.

Royal Ulster Constabulary (RUC) detectives who investigated the attack, the report says, concluded "that the priest was the IRA's director of operations in South Derry and was alleged to have been directly involved in the bombings and other terrorist incidents".

But they failed to act on the intelligence and evidence they had gathered because senior police officers intervened to prevent them interviewing him, the report adds: "Police ombudsman investigators spoke to a former special branch detective who said he had wanted to arrest Father Chesney in the months after the bombing," it explains, "but that this had been refused by the assistant chief constable (ACC) special branch, who had advised that 'matters are in hand.'"

Senior politicians feared the arrest of a priest in connection with such an atrocity – at a time when sectarian killings in Northern Ireland were out of control and the province stood on the brink of civil war – could destabilise the security situation even further.

A deal was therefore arranged behind closed doors to remove Chesney from the province without provoking sectarian fury. Documents seen by the police ombudsman show that the ACC wrote to the Northern Ireland Office (NIO) on 30 November 1972 saying that he had been considering "what action, if any, could be taken to render harmless a dangerous priest, Father Chesney", and suggesting: "Our masters may find it possible to bring the subject into any conversations they may be having with the cardinal or bishops at some future date."

An NIO official wrote back a week later confirming that the secretary of state, Willie Whitelaw, had held a meeting with Cardinal Conway, the head of the Catholic church in Ireland, and: "The cardinal said that he knew that the priest was a very bad man and would see what could be done. The cardinal mentioned the possibility of transferring him to Donegal."

A number of senior RUC officers, including the then chief constable, Sir Graham Shillington, saw the correspondence. Shillington commented on the letter: "I would prefer Tipperary". (Donegal is only just across the border with the Irish Republic; Tipperary is 200 miles south.)

Church records confirm the deal: "An entry in Cardinal Conway's diary for 5 December 1972 confirms that the meeting with the secretary of state took place. It records that he had a "rather disturbing tête-à-tête at the end about C".

Chesney was subsequently ordered to take sick leave in early 1973, and was transferred to a parish in County Donegal later that year. When questioned by his superiors, he denied involvement in the Claudy bombings. He died in 1980.

The Northern Ireland secretary, Owen Paterson, said: "For my part, on behalf of the government, I am profoundly sorry that Father Chesney was not properly investigated for his suspected involvement in this hideous crime, and that the victims and their families have been denied justice.

He added: "My anger at the actions of those responsible for the attack is matched in strength by my sorrow that the survivors of the atrocity and the relatives of the dead did not see those responsible brought to justice for their crimes.

"I recognise, of course, that all those involved in combating terrorism at the time were making decisions in exceptionally difficult circumstances and under extreme pressure."

In a joint statement Seán Brady, the archbishop of Armagh, and Séamus Hegarty, the Bishop of Derry, described the bombing as "an appalling crime", saying: "We accept the ombudsman's findings and conclusions."

They added: "Throughout the Troubles, the Catholic church, along with other churches in Northern Ireland, was constant in its condemnation of the evil of violence. It is therefore shocking that a priest should be suspected of involvement in such violence.

"This case should have been properly investigated and resolved during Father Chesney's lifetime. If there was sufficient evidence to link him to criminal activity, he should have been arrested and questioned at the earliest opportunity, like anyone else. We agree with the police ombudsman that the fact this did not happen failed those who were murdered, injured and bereaved in the bombings."

It is believed Chesney joined the south Derry brigade of the IRA in early 1972 in response to the killings of civil rights protesters in Derry on Bloody Sunday by British soldiers.

All the senior figures involved in the deal to remove Chesney and hush up his role have since died. The police ombudsman's inquiry stresses there is no evidence to suggest that any intelligence was discovered before the attack that could have prevented the atrocity.

In a highly critical conclusion, the report states: "For senior police officers to have had the weight of intelligence and information that they had pointing to Father Chesney's possible involvement in terrorism and not to have pursued lines of inquiry, which could potentially have implicated him in or eliminated him from the investigation, was wrong and compromised their investigation into the Claudy bombings."

The decision amounted to collusion between the church and the state, according to the police ombudsman, Al Hutchinson. "I accept that 1972 was one of the worst years of the Troubles and that the arrest of a priest might well have aggravated the security situation," he said. "Equally, I consider that the police failure to investigate someone they suspected of involvement in acts of terrorism could, in itself, have had serious consequences.

"In the absence of explanation the actions of the senior RUC officers, in seeking and accepting the government's assistance in dealing with the problem of Father Chesney's alleged wrongdoing, was by definition a collusive act."

Had the participants in the deal still been alive, Hutchinson said, "their actions would have demanded explanation which would have been the subject of further investigation".