Senior Labour MP Tom Watson has accused Labour of botching its response to the Unite controversy in Falkirk, saying his party has been guilty of a "huge injustice". The former general election co-ordinator said the party had created a storm in a teacup by calling in police over allegations that Unite tried to stitch up the selection of Labour's candidate to fight a byelection.

Speaking for the first time since his resignation from the shadow cabinet, Watson told the Guardian that Unite did not recruit a single member to the Falkirk Labour party without their consent and could not have fixed the process. He also questioned the suspension of two Labour members – Karie Murphy, the Unite-backed candidate, who was Watson's office manager, and the Falkirk party chairman, Stephen Deans – arguing that evidence against them was inaccurate, unreliable and had been withdrawn.

Watson said Labour's decision to refer the allegations to the police was "silly, bordering on a counter-claim for wasting police time".

Police have ruled out a criminal inquiry into the matter.

Watson's comments are likely to re-ignite the poisonous row over party leader Ed Miliband's handling of the controversy and Labour's relations with its biggest financial backers, the trade unions.

On Friday evening, the Labour party said Watson's version of events was wrong and no evidence under investigation by the party had been withdrawn.

It said Miliband had made a clear choice between "old, machine politics and clean, transparent politics" by taking the allegations extremely seriously.

Miliband has been under pressure following criticism from Labour MPs over the party's lack of direction and unclear messages in recent weeks.

The new attack from Watson threatens to open up another schism between the leadership and a senior party figure who rose to public prominence over his dogged pursuit of the phone-hacking scandal and stepped down six weeks ago while the controversy over Falkirk was raging.

The controversy stems from the selection race to replace Eric Joyce, MP for Falkirk, who resigned from the party after admitting assault in a Commons bar brawl. Following complaints about the process, Labour launched an investigation into whether Unite signed up members to the party without their knowledge to help elect the union's favoured candidate in a safe Scottish seat.

Watson, a former Unite official, was subsequently accused of helping the union orchestrate a string of parliamentary selections designed to secure seats for Unite members, or its union allies. Labour officials exonerated Watson from any wrongdoing in Falkirk or elsewhere, but he resigned anyway, saying he wanted to preserve party unity.

In the wake of the controversy, Miliband promised reform of Labour's funding by the unions to make sure every member deliberately opts to donate to the party, threatening millions of pounds in campaign financing. He also provoked an unprecedented row with Unite, Labour's biggest financial backer, by suggesting it should bear some responsibility for the scandal. Now Watson has decided to make his unhappiness known about his party's handling of the whole affair.

According to him, it was a rival candidate in the Falkirk nomination race who made the initial complaint against Murphy's Unite team. When the party asked for proof, it received two letters from new Labour members in Falkirk, he said.

Watson said neither of the letters' senders were even members of Unite, nor had they been recruited through the trade union membership scheme, under which the union pays the party membership fees. He said both letters were in the same handwriting, in block capitals. Both senders subsequently withdrew the letters and signed affidavits to say they had willingly joined the party, their letters had been drafted by a third party, and the content was inaccurate, he said.

According to Watson, the only text of a complaint to actually appear in Labour's final report was the content of an email from the rival candidate who first made the allegation against Murphy's Unite team. Watson understands that the Labour party officials who suspended Murphy and Deans were not even shown the original copies of the withdrawn letters. Nor, as far as Watson knows, were party officials made aware of the signed statements subsequently made by the two people who had sent them.

"Even now Karie and Stephen Deans have not been formally asked for their version of events. They've been suspended from the party, face a disciplinary that could include expulsion, their conduct reported to the police. They are the subject of unattributed press briefings from party 'insiders' and 'spokespeople' – and have never been given the right to account for their actions."

Watson believes a "huge injustice" has been done to Murphy. "When they finally complete this inquiry they will find out that she hasn't done anything wrong."

Labour strongly disputes Watson's version of events and his criticism of the investigation. A spokesman said: "Tom is wrong. Throughout this process Ed Miliband acted swiftly and thoroughly to uphold the integrity of the party and would take the same action again. No evidence has been withdrawn and reporting the matter to the police was done on legal advice. Ed Miliband has always and will always choose openness, integrity and transparency."

Labour sources said the two letters were a "red herring" and the party had looked at a substantial body of potential evidence.

Watson said he agreed with Miliband that the party needed to be more transparent and called on his leader to publish the report into the Falkirk allegations in full. "I feel that the two suspended members, who have over 50 years of voluntary service to Labour between them, deserve a fair hearing rather than trial by spin doctor," he said.

Watson claims senior Labour figures hostile to the unions have exploited the row in Falkirk.

"I don't think there's anything revelatory about the fact that there's a group of people who would rather there not be a union link within the party, and they seized on this. Peter [Mandelson] jumped in straight away," he said in the interview. He called instead for the unions to be given a much greater role within Labour politics.

"There is not a great deal of logic to unions giving this huge amount of money to Labour if they feel they're not even participating in the party they founded," he said.

Watson blamed New Labour for creating a "crisis of relevance, of political parties themselves", saying: "We've had nearly two decades now of this political media nexus where political leaders think politics has to be compressed in the centre ground. The electoral formula that got New Labour elected was successful for its times, but we were left stranded in an arid desert of pragmatism, and we need a route map out of that."

However, he praised Miliband's leadership, saying: "He's got the calmness of Attlee and the analysis of Tony [Blair]. There might be reasons why the Labour party's not getting its message across, but it's not Ed."

But he blamed other colleagues for making the shadow cabinet disunited and ineffective. "They certainly need to behave more collectively and back each other up more." He said some, such as Andy Burnham, were "motoring in their brief", but others were "certainly not".