The City watchdog will tighten regulation over the sale of payment protection insurance (PPI) after a review found that customers were kept in the dark over the policies' true costs.

Today's announcement from the Financial Services Authority (FSA) is a blow to Britain's banks - already reeling from market turmoil and the collapses of HBOS and Bradford & Bingley - which make around £2.2 to £2.6 billion a year from sales of the cover, according to the Competition Competion.

The FSA said that it would now consider the action it will take to deal with "ongoing non-compliant sales practices". Jon Pain, managing director fof the FSA's retail markets, added: "Firms may wish to consider stopping selling single-premium PPI sold alongside unsecured personal loans, given the the continuing problems in the sales of this product."

The watchdog said that "very few" mystery shoppers who purchased such products under its review were informed that the cost of the policy would be added to the loan and that interest would be charged on the amount. Moreover, only half of them were told of "key limitations and exclusions" "fundamental" to establishing a customer's need.

Earlier this month, the FSA was urged by the Financial Ombudsman Service to do more to prevent the mis-selling of PPI. The ombudsman said that it was handling more than 500 complaints a week about the insurance, which is sold alongside loans, credit cards and mortgages to cover repayments if the borrower becomes unable to pay due to accident, sickness or unemployment.

One common complaint is that the customer did not realise he or she was being sold PPI alongside a credit card or loan. Others are that the cost of the policy was not adequately explained or that it was unsuitable, as the customer could never claim given his or her working patterns or medical history.

Peter Vicary-Smith, chief executive of Which?, the campaign group, said: "This damning evidence demands that the FSA stops dithering and and takes decisive action to sort out the PPI market. Its weak response to date has done little to help the millions of people who may have been mis-sold policies or to improve sales practises."

A spokesman for the British Bankers' Association, said: "PPI is a valuable product which provides customers with a safety net to meet their financial commitments. This is particularly important in these times of economic uncertainty when PPI can provide peace of mind for millions of customers.

"The UK banking industry has been working with the FSA to ensure that literature and sales processes live up to all regulatory standards and products meet customers’ needs. We will take on board the lessons from the FSA's thematic review and continue to work with them to further improve processes where necessary."

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