A two-year corruption investigation by the Serious Fraud Office (SFO) into a £60 million "slush fund" that was allegedly set up for members of Saudi Arabia's royal family was discontinued today.

Payments, in the form of lavish holidays, a fleet of luxury cars including a gold Rolls-Royce, rented apartments and other perks, are alleged to have been paid to ensure the Saudis continued to buy from BAE under the so-called Al-Yamamah deal.

The announcement by Lord Goldsmith, the Attorney General, follows threats by Saudi Arabia to suspend ties with Britain unless Downing Street intervened to block the investigation.

British businesses also complained that the multi-million pound investigation was damaging commercial relationships with Saudi Arabia and could put at least 10,000 jobs at risk.

The Saudis were furious about the criminal investigation by the SFO into allegations that BAE Systems, Britain's biggest defence company, set up a fund to support the extravagant lifestyle of members of the Saudi royal family.

The House of Saud's embarrassment and frustration over the inquiry was said to threaten not only a £10 billion contract to buy Eurofighter combat aircraft from BAE Systems, but other lucrative deals with British defence and industrial companies.

British companies earn about £5 billion a year from defence exports, a quarter of which comes from Saudi Arabia.

Lord Goldsmith said the SFO had advised in a statement that its decision was taken after representations made "both to the Attorney General and the Director (of the SFO) concerning the need to safeguard national and international security."

The statement continued: "It has been necessary to balance the need to maintain the rule of law against the wider public interest.

"No weight has been given to commercial interests or to the national economic interest."

Lord Goldsmith said he had obtained the views of Prime Minister Tony Blair and Des Browne, Defence Secretary, on the public interest considerations raised by the case.

"They have expressed the clear view that continuation of the investigation would cause serious damage to UK/Saudi security, intelligence and diplomatic cooperation, which is likely to have seriously negative consequences for the UK public interest in terms of both national security and our highest priority foreign policy objectives in the Middle East," he added.

Previously senior Saudi businessmen have said it was a huge mistake for Britain to alienate the royal family, which controls all government contracts.

Key figures in the Saudi royal family were understood to feel badly betrayed by the Government over public disclosures made during the SFO investigation into alleged corruption.

One key Saudi official had said: "The Kingdom is very bothered by the leaks made by people inside the British Government. Some documents were released when they should not have been.

"We are beginning to feel that somebody is deliberately trying to embarrass the Kingdom. It is a matter for the British to clear up.

Al-Yamamah is the biggest defence contract in British history and has kept BAE in business for 20 years.

It was signed in 1985 when Britain agreed to sell 72 Tornados and 30 Hawk aircraft to Saudi Arabia. The deal was renewed in 1993 when the Saudis agreed to buy another 48 Tornado warplanes. This year Saudi Arabia agreed to pay £10 billion for 72 aircraft, part of a package that was expected to grow.

At least five people have been arrested in the probe. They include Peter Wilson, BAE's managing director of international programmes, and Tony Winship, a former company official who oversaw two travel and service firms that are alleged to have been conduits for the payments. Both deny any wrongdoing.