The justice secretary, Chris Grayling, has called in the City of London police to investigate alleged fraud by Serco staff working on a £285m contract to transport prisoners to and from courts across London and East Anglia.
Grayling said it had "become very clear there has been a culture within parts of Serco that has been totally unacceptable".
Last month, Grayling asked the Serious Fraud Office to investigate potential overcharging by tens of millions of pounds by the private security company G4S on a £700m contract for the electronic tagging of offenders.
The Ministry of Justice (MoJ) said detailed audit work initiated as a result of the investigation into the tagging contract in July had shown that some Serco staff were recording prisoners as having been ready for court when in fact they were not. This data is a key performance measure for the contract that could determine whether or not it is terminated.
It is thought the "potentially fraudulent behaviour" has been going on since last summer, when persistent delays in transporting prisoners between jails and courts led to an official improvement notice being issued.
It is alleged that instead of ending the delays, Serco staff simply fiddled the paperwork, for example by recording the time that the van arrived at court as if that meant prisoners were ready to appear in the dock.
The ministry said in a statement: "MoJ has informed Serco in the light of the new evidence, it is putting the contract under administrative supervision with immediate effect. Serco have agreed to repay all past profits made on the prisoner escorting and custodial services contract and to forgo any future profits."
The decision to call in the City of London police is particularly embarrassing for Grayling as two of his department's major private sector suppliers are now being investigated for fraud at a time when he is trying to accelerate the pace of his probation and prison outsourcing programme.
Serco is also involved in the allegations involving overcharging on the bigger tagging contract, but unlike G4S it agreed to co-operate with an outside forensic audit to establish whether there had been any dishonest behaviour on its part.
Ministry sources said Serco had asserted that no member of the company's board had any knowledge of the alleged fraud on the prisoner transport contract. "If any evidence of corporate as opposed to individual wrongdoing emerges, MoJ will terminate this contract," it said.
The company has been put on three-month notice that it will have to overhaul its management, strengthen its internal audit procedures and open up its accounts to much more intense government scrutiny.
After three months a specially convened committee of government non-executive directors will assess whether the necessary changes have been put in place.
"Unless government is satisfied the changes made by the company are sufficient to guarantee the future integrity of government contracts, Serco will face exclusion from all new and future work with the government," the MoJ said.
The threat is serious for Serco which is one the government's most important private sector suppliers managing services that range from running prisons and local education authorities to the atomic weapons establishment.
Grayling said: "We have not seen evidence of systemic malpractice up to board level, but we have been clear with the company: unless it undertakes a rapid process of major change, and becomes completely open with government about the work it is doing for us, then it will not win public contracts in future. The taxpayer must know that their money is being properly used."
Chris Hyman, chief executive of Serco, said: "The justice secretary is right to expect the highest standards of performance from Serco. I am deeply saddened and appalled at the misreporting of data by a small number of employees on the contract.
"This is a very serious matter for the customer and for us. We will not tolerate any wrongdoing and that is why we have referred this matter to the police. It is also why I have immediately initiated a programme of change and corporate renewal.
"The overwhelming majority of our people work hard every day to deliver important public services and will share my deep concern about this matter."
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