Gordon Brown faces the humiliating prospect of having to return hundreds of millions of pounds that has been reclaimed in overpaid tax credits in the latest blow to the complex benefit system he introduced.

Officials broke the law for more than three years by failing to tell claimants that their tax credit awards were under investigation, The Times has learnt. Ministers admit that at least 250,000 cases will have to be reviewed.

George Osborne, the Shadow Chancellor, is demanding an inquiry by the independent spending watchdog into the affair. A whistleblower in Revenue & Customs has told the Tories that the final bill could top £500 million.

Almost £6 billion has been overpaid in tax credits because of fraud and error since they were introduced three years ago. Critics say that the system’s complexity explains why so many families fall foul of means-testing rules and face repayment demands often running into thousands of pounds. Familes are supposed to tell the taxman when their circumstances change and hand back any overpayments. In reality many forget, do not understand the rules or simply try to cheat the system.

Now it has emerged that 160,000 repayment demands made between 2003 and 2005 may have been illegal and will have either to be abandoned or, where the money has already been clawed back, repaid. Another 90,000 more recent cases are also to be reviewed. Elizabeth Barlow, a paediatric nurse and single mother from East Yorkshire, won her two-year battle to prevent Revenue & Customs clawing back £2,500, after The Times took up her case.

She had been overpaid after officials wrongly entered her child-care costs as £1,800 per week, rather than per year. Miss Barlow said: “I have no doubt that it will take them years to sort this out, and whether others who didn’t manage to successfully appeal will ever see any money is another point. It was a massive stress.”

Jane Kennedy, the Financial Secretary to the Treasury, told MPs of “an administrative problem with a number of older tax credit awards” in a parliamentary statement slipped out in the last days of the summer session. “It has come to my attention that officials did not follow the correct procedure when reopening some of these cases.” Ms Kennedy said.

The Tories say, however, that the situation is far worse than is being admitted and could take three years and more than half a billion pounds to resolve. The whistleblower told them that Revenue & Customs has been found to have been routinely breaking Section 18 of the Tax Credit Act 2002 by reopening tax credit awards without notification, even though there is no evidence of fraud. The Government now faces repaying money that was subsequently clawed back.

The official’s account, passed to The Times, states that Alistair Darling, the new Chancellor, was told about the issue shortly after taking over from Mr Brown. “New ministers are furious as they realise that the full extent of the issue would be a major political embarrassment. It has undermined ministers’ confidence in officials at the Treasury/HMRC [Her Majesty’s Revenue & Customs] in their first days,” states the anonymous official. “The fiasco was ‘announced’ to the House in an obfuscating written statement in the run-up to the end of session. Everyone at the Treasury/HMRC are congratulating themselves that the announcement was unnoticed.”

Mr Osborne said that Mr Brown must take responsibility. “Look at the small print and you will see that this latest tax credits fiasco happened on Gordon Brown’s watch,” he said. “He must take responsibility and he must answer the key question: when did he first know there was a huge problem and how long did he keep it secret?”

Revenue & Customs confirmed that the problem related to section 18 of the Tax Credit Act 2002. “This is an administrative issue, affecting a small proportion of older tax credit awards, which were revised in the light of new information after the award had been finalised,” a spokesman said. “We have written to all households affected, explaining that we are reviewing their award, and that they will not be disadvantaged as a result.”

He added that it was impossible to put a figure on the amount that would have to be repaid but that £500 million was a massive overestimate.