Future Government rail plans have been thrown completely off track after ministers scrapped a deal which would have seen Sir Richard Branson's train company lose its West Coast franchise.

Sir Richard had mounted a legal challenge to the decision by the Department for Transport (DfT) to award a new 13-year franchise for the West Coast not to Virgin Rail but to rival transport company FirstGroup.

The DfT had intended to contest the matter in court and was still hoping FirstGroup would take over the London to Scotland route as planned on December 9. But in an embarrassing U-turn for the Government, Transport Secretary Patrick McLoughlin said he was cancelling the competition for the running of the West Coast franchise "because of deeply regrettable and completely unacceptable mistakes made by my department in the way it managed the process".

Mr McLoughlin said the DfT would no longer contest the judicial review and had paused all outstanding franchise competitions pending two independent reviews he has set up.

Sir Richard, who had described the bidding process as "flawed" and "insane", welcomed the decision and said he he was hopeful Virgin would carry on running the franchise which it has been operating since 1997. FirstGroup said it was "extremely disappointed" at the news, saying it had submitted "a strong bid, in good faith and in strict accordance with the DfT's terms".

An announcement is expected to be made later about the suspension of Government staff while the department investigations are conducted. FirstGroup's shares were 15% down in early trading.

Labour leader Ed Miliband described the West Coast Main Line decision as a "fiasco" which brought the Government's competence into question. Mr Miliband told BBC Radio 5 Live: "When you look at the latest fiasco with the West Coast Main Line - another Government screw-up, another Government mistake, another case of them blaming someone else, apparently they are saying it is the fault of their civil servants - I think competence is an issue."

Bob Crow, general secretary of the RMT transport union, said: "The whole sorry and expensive shambles of rail privatisation has been dragged into the spotlight this morning and instead of rerunning this expensive circus, the West Coast route should be renationalised on a permanent basis."

The DfT said it could not be confident that the flaws would not have changed the outcome of the competition or that any of the four bidders would not have chosen to submit different offers. All the bidders have been contacted by the DfT and will have their bid costs reimbursed, it added. The Government said a fresh competition will be started as soon as "the lessons of this episode are learned".

Writing on his blog on the Virgin website, Sir Richard said: "From the moment we found out that FirstGroup had been made the preferred bidder with a completely unrealistic bid, we questioned the way the offers had been assessed, and asked the Government to review and explain how it came to its decision. We were convinced the process was flawed but despite our best efforts we were met with silence by the DfT."