A furious row between Nato-led forces and the Afghan president over the killing of civilians looks set to turn into a full-blown crisis after an elderly cousin of Hamid Karzai was killed during a botched Nato operation.

Officials in the southern province of Kandahar confirmed that Haji Yar Mohammad Karzai, a second cousin of the president, was accidentally shot during an overnight operation in the family village of Karz.

Senior tribal leaders, including Karzai's powerful brother Ahmed Wali Karzai, had gathered for the funeral in keeping with the Islamic tradition of burying the dead within 24 hours.

Athough details are scarce, it appears that a major intelligence failure could have been responsible for the deaths after Nato's International Security Assistance Force (Isaf) issued a statement correcting an earlier press release that had claimed a man killed in operations in the area was the father of a Taliban leader.

The original statement said the Taliban leader was being targeted for distributing materials to make car bombs that were being used throughout Kandahar province. It said soldiers had approached a compound and called for all the people inside to come out so they and the building could be searched.

Deadly force was used after a man was seen carrying a weapon, according to the first statement: "A member observed an armed individual with an AK-47 in an adjacent building within the same compound. The security force assessed the male as an immediate threat to the security force, and engaged him. The individual killed was the father of the targeted individual. The leader and suspected insurgents were detained as a result of initial questioning at the scene."

The new statement said the coalition was "now aware of conflicting reports about the identities of those involved" and an inquiry had been launched.

Karzai's spokesman, Waheed Omar, said the president had ordered an immediate investigation by Afghan security forces.

"Like always with any other civilian casualty the president was saddened because he takes the loss of life extremely seriously," Omar said.

Details of what happened are still unclear, although one senior member of the Alokozai tribe, who attended the funeral, said the attack took place at some point after midnight and American soldiers were responsible.

"There were many tanks that came and surrounded the house, but they did not attack any other building," said Haji Padshah. "The Americans then went in, brought out Haji Mohammad and shot him."

Ahmadullah Nazak, district chief of the area, said two of his bodyguards and a neighbour were arrested in the operation.

"We don't know why the operation was carried out in his village, whether he [Karzai's cousin] was aimed at or somebody else. He was an old man at the age of 60, he had no official job," Nazak said.

Mahmoud Karzai, another of the president's brothers, said the killing was a "shocking development" and he could not understand why Nato forces would be hunting for insurgents in Karz, which is in the relatively peaceful district of Dand, not far from Kandahar City.

"Karz is our stronghold, there are absolutely no Taliban there and there never will be," Mahmoud Karzai told the Guardian.

He said he "smelled a very deep conspiracy" behind the episode, possibly involving a family feud within the Karzai clan that goes back to the jihad period of the 1980s.

"If this is a deliberate setup where the US military is being given false information to settle a personal vendetta then this is very serious," he said. "I hope there is a full investigation."

He said the president was not close to his cousin and they had not seen each other for a long time.

Nonetheless, the murder of a relative in a country where family and tribe is all-important is likely to stoke government rage at Nato blunders.

The timing of the incident is especially unfortunate as Karzai has been ratcheting up his criticism of the Nato-led coalition for killing civilians, particularly after nine boys were killed recently when an attack helicopter mistook them for insurgents.

Although figures released by the United Nations on Wednesday showed that 75% of civilian deaths in 2010 were caused by insurgents, Karzai has tapped into public rage at the accidents of foreign troops, in part to confound the widespread view that he is a puppet of the US.

He even rejected an apology made by General David Petraeus, commander of Nato and US forces in Afghanistan, after the incident with the nine boys.