A project to spy on two Muslim areas in Birmingham using more than 200 CCTV cameras has been dramatically halted after an investigation by the Guardian revealed it was a counterterrorism initiative.

Bags are being placed over the cameras, recently installed in the neighbourhoods of Washwood Heath and Sparkbrook, to reassure the community their movements are not being monitored while a "full and in-depth consultation" takes place.

In a joint statement last night, West Midlands police and Birmingham city council announced the cameras would not be turned on. They apologised for not being "more explicit" about the funding arrangements of the project, which stipulated they should be used to combat terrorism, a mistake they conceded may have "undermined public confidence".

But officials insisted the £3m project would go ahead following a retrospective public consultation, arguing the cameras would help reduce crime.

Under the initiative, Project Champion, two suburbs were to be monitored by a network of 169 automatic number plate recognition (ANPR) cameras – three times more than in the entire city centre. The cameras, which include covert cameras secretly installed in the street, form "rings of steel", meaning residents cannot enter or leave the areas without their cars being tracked. Data was to be stored for two years.

There was no formal consultation over the scheme, which includes an additional 49 CCTV cameras. The few local councillors who were briefed about the cameras appearing in their constituencies said they were "misled" into believing they were designed to tackle antisocial behaviour, drug dealing and vehicle crime.

There were angry public meetings in the city last week, after the Guardian disclosed the cameras were paid for by the Terrorism and Allied Matters (Tam) fund, administered by the Association of Chief Police Officers. Its grants are for projects that "deter or prevent terrorism or help to prosecute those responsible".

Senior officials involved in the Safer Birmingham Partnership (SBP), a partnership between the police and council tasked with overseeing the project, were unaware of the counterterrorism link until just two months ago.

The partnership said in a statement: "We completely accept that earlier consultation with councillors from Sparkbrook and Washwood Heath – the main focus of the project – should also have included elected representatives from all other areas affected.

"We also accept that we should have been more explicit about the role of the counterterrorism unit in the initial project management of Champion.

"Although the counterterrorism unit was responsible for identifying and securing central government funds, and have overseen the technical aspects of the installation, the camera sites were chosen on the basis of general crime data – not just counterterrorism intelligence.

"Day to day management of the network was always intended to become the responsibility of local police. We apologise for these mistakes, which regrettably may have undermined public confidence in the police and the council."

Testing of cameras had already begun, and officials had planned to go live in early August.

However, the plans were placed in jeopardy after a public outcry over the scheme. Human rights lawyers have pledged to seek a judicial review of the scheme.

Parliament has been asked to denounce Project Champion as a "grave infringement of civil liberties" in an early day motion tabled this week by the Labour MP for Birmingham's Hall Green constituency, Roger Godsiff.

Police sources said the initiative was the first of its kind in the UK that sought to monitor a population seen as being "at risk" of extremism.