David Blunkett, the Home Secretary, wants a change in the law to prevent a recurrence of the "extraordinary" decision to release an Algerian terror suspect from prison on mental health grounds.

The 35-year-old Algerian prisoner, known only as "G" for legal reasons, is thought to have "actively assisted" terrorists linked to al-Qaeda. He suffers from polio and had become psychotic since his detention in December 2001.

He was freed from Belmarsh high-security prison in south-east London yesterday because the Special Immigration Appeal Commission (SIAC) accepted that his continuing detention under Mr Blunkett's controversial anti-terror laws was prolonging his illness.

But Mr Blunkett said today: "Allowing someone like this out on bail is an extraordinary decision which puts massive pressure on our anti-terror and security services, and sends a very different signal to the one we have been sending.

"I have not called it bonkers, but no doubt other people will."

Mr Blunkett said that medical experts who assessed G had concluded that he did not require psychiatric accommodation.

The prisoner had also been offered a place at a specially created unit for Muslim inmates at HMP Wood Hill, near Milton Keynes, but had refused.

Mr Blunkett said: "I almost cease to be amazed these days by decisions which are sometimes taken, but we are very clear that we will have to amend the law to ensure that whatever steps are necessary to protect the public we can take."

In October, as the SIAC rejected G's appeal to be released from detention. It said: "We have no doubt that he has been involved in the production of false documentation, has facilitated young Muslims to travel to Afghanistan to train for jihad and has actively assisted terrorists who have links to al-Qaeda."

Gareth Peirce, G’s solicitor, said after yesterday’s hearing: "The Home Secretary has been fighting this to the death.

"He has tried to stop this man from getting out and getting sane. He drove this man to madness. This is not what should happen in a civilised society."

Mark Oaten, Liberal Democrat home affairs spokesman, said: "The case creates a precedent, and is a serious blow to David Blunkett’s system of detention without trial.

"The Home Secretary should accept this ruling and move quickly to ensure that the proposed house arrest is legal and will not be subject to further challenges."

G was being detained under the Anti-Terrorism, Crime and Security Act, passed within weeks of the September 11 attacks.

The Act allows foreigners to be detained indefinitely without charge or trial if the Home Secretary rules they are suspected of involvement in international terrorism.

Of the original 16 held, one has now been freed, one bailed and two have left voluntarily for destinations abroad.

The decision to reject the Home Secretary’s attempt to keep G in prison came after an earlier blow when one of the original 16 terror suspects was set free after his appeal was accepted. He was known as M and came from Libya.

Even some members of the court staff expressed surprise privately that G had been set free and predicted that others from the 12 remaining detainees would now also make applications for bail on the ground of the deterioration of their mental health.

Much of yesterday's hearing turned on the evidence of Professor Ian Robbins, a mental health expert from the University of Surrey, who claimed that recent improvements in G’s mental condition had come about only because of the original bail decision in January.

G will remain at home on bail for which his wife put up a £500 surety under a list of stringent conditions.

These include having to make five calls a day at strict times to the tagging company, a ban on any form of communication other than a dedicated telephone to those responsible for the tagging, a ban on all computer equipment that might enable him to connect to the internet and the order to remain in his flat except for three-monthly reviews under police escort.

Apart from his wife and child and designated medical personnel who will monitor his mental state, he is permitted no visitors unless those have already received Home Office approval. But it is understood that there will be no police presence permanently in the flat.