Abu Dhabi is trying to rip up its disastrous $7.5bn (£4.6bn) agreement to invest in Citigroup, saying the banking giant misled the country's sovereign wealth fund about the state of its finances when the deal was signed in 2007.

The dispute came to light as Citigroup was attempting to stoke investor demand for a massive share issue yesterday and contributed to underwhelming investor demand. Faced with crystallising a loss on its bailout investments, the US Treasury abandoned plans to sell part of its Citigroup stake at the same time.

The oil-rich emirate is committed to buying Citigroup shares over the next two years at what is now 10 times the prevailing share price, and it has launched an arbitration claim for compensation to the tune of $4bn.

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The Abu Dhabi Investment Authority (Adia) said Citigroup made "fraudulent misrepresentations" in connection with the agreement, but declined to provide specifics. "It is the policy of Adia to pursue its legal rights fully," a fund spokesman said. "Adia declines to comment further due to binding confidentiality obligations, which Adia intends to respect."

Citigroup promised to vigorously defend the arbitration claim.

The $7.5bn investment in Citigroup was unveiled by Adia in November 2007, when it seemed that money from the sovereign wealth funds of developing nations, particularly in the Middle East where the benefits of high oil prices were being felt, might be the best way to recapitalise the US banking system. Citigroup had begun to show losses on its sub-prime mortgage investments earlier in the year, but said it was moving to strengthen its balance sheet.

The subsequent collapse of the company, which twice had to be bailed out by the US government during the financial panic of last year, is therefore a big embarrassment to Abu Dhabi. "Citi possesses a unique position in the financial markets throughout the world," Adia's managing director, Sheikh Ahmed bin Zayed al-Nahayan, had said at the time. "We see in Citi a highly respected company with a premier brand and with tremendous opportunities for growth. This investment reflects our confidence in Citi's potential to build shareholder value."

Under the complex structure of the deal, Abu Dhabi agreed to buy shares in Citigroup at what was then close to the prevailing share price, but in several tranches in 2010 and 2011. Adia has been paid an 11 per cent dividend in the meantime, but now faces buying 236 million shares at $31.83 – when Citigroup was trading yesterday lunchtime at $3.57.

The dispute comes at a critical moment for the finances of both sides. Abu Dhabi committed this week to lend $10bn to bail out fellow emirate Dubai, and Citigroup was yesterday trying to raise $17bn as part of its scheme to pay back US government bailout funds.

Its bankers were working on a share sale that they hoped to price significantly higher than the $3.25-per-share level at which the US government invested a $25bn tranche of bailout funds last year. The US Treasury put $45bn into Citigroup in all, because as one of the largest investment and retail banks in the country it was deemed too big to fail. The company said on Monday that it would pay back a $20bn loan immediately and the government would start selling its $25bn equity stake this week.

Last night the US government reversed course saying it would not sell its stake for 90 days after tepid investor demand. The new shares are expected to be priced as low as $3.15.

* Bankrupt holding company Washington Mutual Inc this week asked a federal court to compel the Federal Reserve, US Treasury and more than a dozen others to turn over documents relating to its collapse in September 2008.