Bernard Madoff, the Wall Street financier accused of running a massive swindle that fleeced investors of up to $50bn, is to remain in his lavish Manhattan apartment overlooking Central Park after a federal judge today rejected prosecution calls for him to be jailed.

The decision to allow Madoff to stay under house arrest in the $7m penthouse, rather than transfer him to the Metropolitan Correctional Centre in lower Manhattan, astonished and further angered victims of the scandal. Judge Ronald Ellis refused to revoke his $10m bail, ruling that the prosecution had failed to make its case that Madoff could cause more harm if he remained at large.

But the judge did impose new restrictions that will see all Madoff's mail searched by a security firm before it leaves his building.

An inventory will also be taken of all valuable portable objects in his apartment, which will be checked every two weeks to ensure he is not attempting to dispose of it. The restrictions will apply to both Madoff and his wife.

Madoff was a highly respected Wall Street figure for more than 40 years, at one point holding the post of chairman of the Nasdaq stockmarket. He gained a reputation for earning his clients a remarkably stable and high rate of return.

But last month he was arrested after it was revealed that his financial empire was founded on thin air. He had allegedly been running what is known as a Ponzi scheme — taking in new money to pay the dividends of existing investors, losing up to $50bn and with it the entire life savings of thousands of his clients in the process.

Prosecution lawyers had called on the court to imprison him on the grounds that he broke a court order freezing his assets.

Shortly before Christmas, Madoff posted $1m-worth of jewellery and gifts to friends and family in clear violation of his bail terms. Court papers showed that the items included 13 vintage timepieces, including Tiffany and Cartier diamond watches, an emerald ring, four diamond brooches, two sets of cufflinks and a jade necklace.

The packages were sent by Madoff to his sons, Andrew and Mark, who worked for the family firm, his brother Peter, and his closest friends in New York.

The lead prosecutor, Marc Litt, argued that "the continued release of the defendant presents a danger to the community of additional economic harm and further obstruction of justice".

But Madoff's defence lawyers said the mailings were an innocent mistake: he had sent out family heirlooms and was simply unaware that was in breach of the asset freeze.

Victims and their lawyers reacted angrily to the decision to allow Madoff to remain free. Larry Leif from Palm Beach, Florida, who lost his life savings of $8m, told CNBC: "If I had commited this crime personally, I would be in jail."

Jeffrey Zwerling, a lawyer representing individual and institutional Madoff victims around the world, said his clients would be outraged. "They have just lost their entire life savings, are losing their homes, can no longer pay their health insurance, and here is Madoff living in a triplex overlooking Central Park."

In further evidence of the strange moral universe inhabited by Madoff, the New York Times yesterday revealed that he has been apologising to his neighbours in the East 64th Street block of apartments for the chaos caused by the media camped outside since his arrest.

"Dear neighbours," his letter says, "Please accept my profound apologies for the terrible inconvenience that I have caused over the past weeks. Ruth and I appreciate the support we have received."