Tony Blair's foreign policy has been blamed by Home Office advisers for fuelling the extremism that led to the London bomb blasts in July.
Senior Muslims appointed to investigate the causes of the attacks, in which 52 people were killed, also warned that the Home Secretary's anti-terror legislation could prove dangerously counter-productive.
Ministers have always denied any link between the wars in Iraq and Afghanistan and the radicalisation of young British Muslims. But they were contradicted in the final report of seven working parties of Muslim leaders, set up by the Home Office after the attacks.
It concluded: "British foreign policy - especially in the Middle East - cannot be left unconsidered as a factor in the motivations of criminal radical extremists. We believe it is a key contributory factor."
The report came a day after Blair's plan to hold terrorism suspects for 90 days without charge was defeated by MPs, his first Commons vote loss in eight years as premier.
The working groups said "radical impulses" among the Muslim community were often triggered by "perceptions of injustices inherent in western foreign policy".
Their conclusions echoed a leaked Government memo in July which found the Iraq war was a key cause of young Muslims turning to terrorism.
Blair's spokesman acknowledged the Government had to do more to explain the "fundamental point" of its policy in Iraq and Afghanistan, which is to bring democracy to those nations.
Hazel Blears, the Home Office Minister, said: "They are telling the Government some fairly challenging things and not just telling [us] what they think we wanted to hear."
Plans to give the police powers to close mosques which are being used by Islamic extremists could deprive law-abiding communities of their place of worship.
And moves to ban radical Islamist organisations, such as Hizb ut-Tahrir and al-Muhajiroun, could send them underground and make them "more problematic in the future".
The working groups also recommended setting up a media unit to counter "Islamophobic" media reporting, setting up a British-Islam website to counter the mass of extremist Muslim sites on the web, and a new drive to teach English to Imams.
Blears said the Government supported the "vast majority" of the groups' 64 recommendations.