Banks have been given a reprieve from paying refunds for overdraft charges.

The move came as seven major banking institutions, in conjunction with the City watchdog and the Office of Fair Trading (OFT), launched a test case on the legality of overdraft penalty fees in the High Court.

If the ruling goes in favour of customers, hundreds of thousands of whom have already reclaimed bank charges in the past year, it could cost the banks £10 billion. It could also lead to the end of “free” current accounts as banks try to recover costs.

The OFT said: “The banks do not accept that the unfairness rules of the Unfair Terms in Consumer Contract Regulations apply. The OFT believes that they do and is seeking to establish this legal principle in court.”

The Financial Services Authority (FSA) said that banks could suspend paying refunds to customers from today until the court case is decided.

Angela Knight, the chief executive of the British Bankers’ Association, last night defended the suspension: “This is a requirement from the FSA. We have to abide by those requirements while seeking the court adjudication. Consumer groups have called for clarity on this issue; this is the way to achieve clarity.” She added: “The banks have always been firmly of the view that the fees they charge customers are fair and clear. The court case will clarify these points and provide certainty for customers and banks alike.”

If the High Court decides that overdraft penalties are illegal, banks may have to repay six years’ worth of fees. The banks make an estimated £1.7 billion each year from penalty charges.

Martin Lewis, from the consumer website Moneysavingexpert.com , said: “It would be a victory if the court decides in favour of customers and says banks must pay back every penny. The banks take our money without asking us; they should give it back without being asked.”

Banks and building societies have paid out an estimated £200 million so far this year in refunds to customers. The banks have settled many claims out of court. Those that did make it to court were decided by county court judges and did not set a precedent.

There is an ongoing investigation by the OFT into overdraft fees, launched last September. It is unclear how long the High Court case will take, but it is hoped that it will be heard this year.

The institutions that have submitted the application are HBOS, Abbey, Barclays, Lloyds TSB, Nationwide Building Society, Royal Bank of Scotland, and the Clydesdale and Yorkshire Banks.