Israel has barred a former security official from giving evidence in a landmark lawsuit in New York over the funding of terrorist organisations, in a move criticised as a capitulation to economic pressure from the Chinese government and a betrayal of US citizens caught up in Palestinian suicide bombings.

The dramatic development in a long-running case instigated by the state of Israel came late on Friday when the Israeli government filed a legal motion to prevent its former agent being subpoenaed as a star witness, citing security concerns. The US judge hearing the case had previously said the agent's testimony was crucial.

The plaintiffs and their lawyers claim the move is to protect economic ties with Beijing. Instead of championing justice for the victims of suicide bombings and attacks, Israel has caved in to Chinese demands, critics say.

Two related cases are being brought by US citizens against the state-owned Bank of China for allegedly allowing the transfer of funds to Hamas and Islamic Jihad, Palestinian militant organisations responsible for suicide bombings that have killed hundreds of people.

One is a group action on behalf of 22 relatives of victims; the other was brought by the father of Daniel Wultz, a 16-year-old boy killed in a bombing in Tel Aviv in 2006. The families are seeking hundreds of millions of dollars in damages.

The origins of the case lie in Israel's discovery eight years ago that funds were being channelled to Hamas and Islamic Jihad via accounts held with the Bank of China. Israeli security officials were dispatched to Beijing to alert the Chinese authorities to the transfer of funds and to request its cessation.

After the Chinese authorities failed to act, Israel sought and found US citizens prepared to sue the Bank of China, which has branches in America, under US anti-terrorism laws. Hamas and Islamic Jihad are proscribed by the US as terrorist organisations.

The former Israeli agent Uzi Shaya, who was part of the 2005 delegation to Beijing, was due to appear for questioning in New York on 25 November. At an earlier hearing, the judge, Shira Scheindlin, said Shaya "may be the only person who really has the knowledge as to what transpired at the [2005] meeting".

Shaya had previously indicated his willingness to testify, but said he needed authorisation from his government. Now Israel has moved to bar the agent from giving evidence on the grounds that it could endanger national security.

In a statement released on Saturday, prime minister Binyamin Netanyahu's office said: "After conducting a comprehensive review of the matter, the state of Israel concluded that it cannot allow the former official to be forced to disclose in foreign legal proceedings any information that came to his knowledge in the course of his official duties.

"The disclosure of such information would harm Israel's national security, compromise Israel's ability to protect within its border, and interfere with international co-operative efforts to prevent terrorism."

It added that Israel "stands with victims of terror and their families and sympathises with their profound agony and pain".

Israel has become alarmed about the impact of the case on diplomatic and trade relations with China. In the runup to a visit by Netanyahu to Beijing in May, the prime minister reportedly gave assurances under Chinese pressure that Israeli officials would not testify in the case.

The two nations have since discussed a bilateral free-trade agreement. The finance minister, Naftali Bennett, said on a visit to China in July that "such an agreement would considerably increase the amount" of trade, currently worth at least $8bn annually.

An article by a trio of prominent columnists in Yedioth Ahronoth described the move as "one of the gloomiest days in the annals of Israel's lengthy war on terrorism". It said a high-ranking delegation from China had visited Israel to meet Netanyahu two weeks ago.

"In the course of the visit, a deal was reached: Israel will refrain from aiding the bereaved families in their suit, and China will not realise its threat to close its doors to the Israeli economy," they wrote. "Israel bowed to the dictates of the Chinese government."

An Israeli lawyer representing the 22 families in the group action said she was "deeply concerned and disappointed" by the Israeli government's move. "Financial engagement" with China should not be "at the cost of abandoning those families who have had loved ones murdered by the Palestinian terror groups who we allege moved funds through the Bank of China," said Nitsana Darshan-Leitner.

Yekutiel Wultz, the father of the teenage boy killed in Tel Aviv, said he had been asked by the Israeli government to bring the case. He told Yedioth Ahronoth: "I'd always felt that I was a soldier the Israeli government had sent to fight for it against terrorism. The government of Israel promised to stand behind me, to give me aid and support.

"After five years I suddenly find that all the commanders have run away. They tell me: fight on your own. Even worse, they say: there's no need to fight, stop fighting."

Naftali Moses, whose son Avraham was killed in Jerusalem in 2008, told the Associated Press: "Netanyahu's office promised to fight terror and they are backing down … They have forgotten the victims of terror in favour of relations with the Chinese."