Nationwide is being paid £1.6bn in return for rescuing most of the Dunfermline building society, which has collapsed under its unsustainable debts after the government declined to bail it out.

Under a deal announced this morning, Dunfermline's retail arm and its £1bn book of healthy mortgages are being transferred to the Nationwide building society following negotiations with the Bank of England. Nationwide is receiving £1.6bn from the government to cover the difference between Dunfermline's liabilities and the assets it is taking on.

Nationwide has declined to take ownership of the high-risk assets, such as self-certification mortgages made at the height of the housing boom. These toxic assets will now transfer to the taxpayer, to sit alongside other bad loans including those made by Bradford & Bingley.

The chancellor, Alistair Darling, told parliament this afternoon that the sale was agreed after the Financial Services Authority (FSA) had concluded that Dunfermline was effectively insolvent, having run up huge losses on commercial property loans. At least £60m was needed to stabilise the building society, but Darling said this would not have guaranteed its long-term future.

"Even if we'd put all this money in, the regulators believe was that it would not be enough," he said.

The shadow chancellor, George Osborne, said the FSA must bear some of the blame for the collapse of Scotland's biggest building society.

"Management must take primary responsibility for taking a safe, and may I say boring, building society and turning it into a high-risk property speculator– but why did the FSA allow them to do it?" Osborne asked.

Vincent Cable, the Liberal Democrat Treasury spokesman, reiterated this point, warning that one of Dunfermline's loans had been made to a company that was "loss-making, insolvent, and had never filed any accounts".

Graham Beale, the chief executive of Nationwide, said the deal would safeguard the savings of 300,000 Dunfermline account holders.

"This is good news for the members of Dunfermline who are now joining the world's largest building society," said Beale. "As members of a solid, stable and dependable organisation, members of Dunfermline can be assured that their savings are safe."

Some job cuts also seem inevitable; Nationwide warned that "some back-office and central group functions of Dunfermline will no longer be required".

There were protests outside the building society's headquarters in Fife today. One demonstrator said they were considering launching a legal action to block the sale.

Local Scottish National party councillor, Brian Goodall, said many staff were worried they might lose their jobs.

Lehman added to Dunfermline's pain

Dunfermline's problems lie at the heart of the credit crunch which has brought havoc to the financial sector. Its property investments include £650m in commercial property and £150m in sub-prime mortgages in England. These are thought to have included loans bought from a subsidiary of failed US lender Lehman Brothers and GMAC, the struggling finance arm of General Motors. It also lost £9m on its own IT system.

Darling warned yesterday these losses meant Dunfermline would have required between £60m and £100m from the taxpayer to prop it up - which it would have struggled to repay. He said Dunfermline, which has £3.3bn in assets, had only made £5m-£6m annual profits at most in recent years: last year it made £2m.

But Dunfermline's chairman, Jim Faulds, claimed this morning that the 140-year-old mutual could have been saved if the government had given it a loan via its liquidity scheme.

"The Treasury didn't want to take the risk ... we could have had a sustainable, independent future," he claimed.

Dunfermline's social housing business will be transferred to the a 'bridge bank' controlled by the Bank of England.

The toxic assets which Nationwide did not take on will be folded into the Building Society Special Administration Procedure. KPMG has been appointed administrator to sell off these assets. The bill for this sale will land on the rest of the financial industry, as the Treasury expects to make a claim on the Financial Services Compensation Scheme.