The government's flagship policy to revolutionise welfare by paying private companies to find jobs for the unemployed was in crisis last night as firms said there were too many people out of work - and too few vacancies - to make it viable.

News that Labour's radical plan is in turmoil and facing possible legal challenges comes as unemployment is about to pass the two million mark for the first time in more than a decade. Analysts believe it will hit three million before the end of this year.

Responding to warnings that his reforms will not work without major changes, James Purnell, the work and pensions secretary, has abandoned plans to announce the preferred bidders for the multi-million-pound contracts this week. This follows demands from the firms involved for hundreds of millions more in "up-front" cash. A crisis meeting between top department officials and the bidding companies was cancelled on Friday after Whitehall announced a "short pause" in the tendering process.

The Department for Work and Pensions (DWP) said it had been called off "because of the snow", but one company manager involved remarked: "The most telling thing is that no new date was set."

The difficulties besetting Gordon Brown's core welfare policy present a severe headache to ministers, who vowed last year - when jobs were abundant and unemployment low - to bring more private-sector rigour into the welfare system by paying employment firms and the voluntary sector "by results". This meant they would receive a sum for each person for whom they found a job, with extra cash when workers stayed in their new posts for more than 26 weeks.

The drive to "privatise" the welfare system is one of the most radical and controversial policies of Labour's entire third-term agenda. Richard Johnson, managing director of welfare-to-work policy at Serco, a provider of "outsourced public services" bidding for eight contracts from the DWP, said it was vital the government rescued the policy - but it would have to be more flexible.

"We recognise that, with twice as many people signing on and three times as many becoming unemployed, the services and funding we agreed 12 months ago is no longer fit for purpose," he added.

Under the current contracts on offer, worth a total of more than £1bn over five years, firms and voluntary sector organisations chosen in a tendering process would be paid 20% "up front" as a service fee and the remaining 80% when they placed people in work. Now many are demanding the service fee element be raised to 50%.

Colin Birchall, chief executive of Pertemps People Development Group, which has been bidding for eight contracts under the "flexible new deal", agreed that the government will have to release more capital at an earlier stage to satisfy bidding companies: "We need to review where we are, because we have a results-driven contract. Because the programme has become larger, the requirement for capital outlay from each company will be greater."

In a further twist, ministers have also been told by the industry that companies which decided last year not to bid for the contracts on the basis that there was not enough up-front cash on offer, may launch legal action against the government if it now offers more generous terms to existing bidders but refuses to start the entire tendering process from scratch.

In a submission to ministers sent on Friday, before the cancelled meeting, and leaked to the Observer, the representative body for the industry - the Employment Related Service Association - suggested the entire bidding process may have to start again.

"The current context is so different from that originally envisaged that, no doubt, the DWP will have considered carefully whether procurement law required the competition to restart from the beginning," says the letter.

Mark Lovell, executive chairman of A4e which is bidding for several contracts, said he had heard that some failed bidders may try to take the government to court once the terms are redrawn. "I have heard about possible legal action, but would caution against it because I think the steps being taken by the government are appropriate. I cannot see what other bidders could say or what information they could provide that would change the outcome," he said.

Mark Serwotka, general secretary of the Public and Commercial Services union, which opposes privatisation, said the policy stood little chance of getting under way as planned in the autumn.

"Nobody can have any confidence in the claim that the flexible new deal can start in October. Any attempts to rescue these flawed plans will result in taxpayers handing a blank cheque to the preferred bidders."

The DWP refused to comment on the problems in the tendering process or the reasons for the delay. But officials insist the policy remains on track. However, a letter sent to bidders by senior officials in Purnell's department on January 30 spelt out the extent of the problem and the need for an urgent rethink.