Whitehall contracts running into billions of pounds are being urgently reviewed after the Government disclosed that two major firms had charged the taxpayer to monitor non-existent electronic tags, some of which had been assigned to dead offenders.

In an announcement that throws the Coalition's privatisation drive into disarray, the Serious Fraud Office was called in to investigate G4S, the world's largest security company, over contracts dating back over a decade.

Serco, one of Britain's largest companies, also faces an inquiry by auditors over its charges for operating tagging schemes.

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The firms supply an array of services to the public sector from running courts, prisons and immigration removal centres to managing welfare-to-work schemes and the Atomic Weapons Establishment.

Between them the two companies receive around £1.5bn a year from the taxpayer, but their contracts are worth billions of pounds because the vast majority run for several years.

They were also hoping to cash in on moves by the Ministry of Justice (MoJ) to hand them further large contracts to operate prisons and supervise offenders in the community.

The process of awarding all contracts was put on hold last night as the inquiries got underway.

The MoJ began investigating all its agreements with the two firms, including the running of major prisons, while the Cabinet Office started scrutinising all other Government contracts with G4S and Serco.

Shares in both companies fell sharply after the announcement by Chris Grayling, the Justice Secretary.

Shares in G4S - which suffered torrid publicity over its mishandling of the last year's London Olympics security contract - finished the day 12.6p down at 213p. Serco tumbled by 54p to 626.5p.

Each of the companies relies heavily on Britain both for income and burnishing its international reputation. The move by the Government is unlikely to result in the wholesale loss of contracts, as the firms have few competitors of the same size but is a blow to their standing worldwide.

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Mr Grayling's announcement came after an audit discovered G4S and Serco had overcharged taxpayers by up to £50m, billing them for offenders who were dead, back in custody or had left the country. According to one MoJ source, the companies charged for 18,000 offenders when the actual number was around 15,000.

Mr Grayling said latest estimates suggested taxpayers had been overcharged by the companies to the tune of “low tens of millions” since the electronic monitoring contracts were signed in 2005. He also disclosed that ministry staff could have known about the practice for five years and face possible disciplinary action.

He said in a Commons statement: “The House will share my astonishment that two of the Government's biggest suppliers would seek to charge in this way.

”The House will also be surprised and disappointed to learn that staff in the Ministry of Justice were aware of the potential problem and yet did not take adequate steps to address it.“

Mr Grayling said he was asking the Serious Fraud Office to investigate the G4S contracts as the company had refused to co-operate with a further audit to rule out wrongdoing.

An investigation by PriceWaterhouseCoopers found that overcharging could have dated back as far back as 1999 when earlier contracts were signed.

Serco has agreed to withdraw from the current tender process for an electronic monitoring contract worth up to £1m, while Mr Grayling plans moves to exclude G4S as it is still attempting to bid.

Serco had also been the leading bidder for prison contracts in Yorkshire, but Mr Grayling will delay their award until the fresh audit is complete.

An urgent review of contract management across the Ministry of Justice's major contracts has also been launched and will report by autumn, he said.

G4S and Serco were also among companies preparing to bid for a range of payment-by-results contracts to supervise low to medium-level offenders across England and Wales.

Ian Lawrence, general secretary of the National Association of Probation Officers union, said: ”We've long maintained that these companies are unfit for purpose when it comes to holding important public contracts. The outcome of the initial investigation into G4S and Serco suggests a good deal of malpractice has been discovered.“

Ashley Almanza, the G4S group chief executive, said: ”We place the highest premium on customer service and integrity and therefore take very seriously the concerns expressed by the Ministry of Justice. We are determined to deal with these issues in a prompt and appropriate manner.“

Serco Group's chief executive, Christopher Hyman, said: ”Serco is a business led by our values and built on the strength of our reputation for integrity.

“These values lie at the heart of the many thousands of our people who are endeavouring to deliver the highest standard of service to our customers around the world. We are deeply concerned if we fall short of the standards expected of all of us.”

Sadiq Khan, the shadow Justice Secretary, said: “Given the scale of the allegations, the Government must immediately call in the police and the Serious Fraud Office to investigate both companies as fraud has potentially taken place.”

Security breach: Other G4S fiascos

* G4S faced fierce criticism last year following the botched handling of its Olympics security contract. It failed to deliver the numbers of security staff it had promised and the Government was forced to bring in additional armed forces personnel. The firm will take a £70m hit over the bungled contract with Games organisers, Locog.

* Earlier this week an inquest jury ruled an Angolan man who died after being restrained by three G4S guards as he was being deported from the UK was unlawfully killed. Jimmy Mubenga, 46, died on a plane bound for Angola in October 2010. The Crown Prosecution Service said it would reconsider its decision not to bring criminal charges in the wake of the verdict.

* In January, multimillion-pound plans by three police forces to outsource services to G4S collapsed. Hertfordshire Police and Crime Commissioner, David Lloyd, said the Bedfordshire, Cambridgeshire and Hertfordshire Strategic Alliance had discontinued negotiations with the firm.

However, last month it was revealed Lincolnshire’s police force now spends the lowest amount per head of population on policing in England and Wales after it handed over the bulk of its back-office functions to G4S.