Lindsay Murdoch, Darwin – Former East Timorese prime minister Mari Alkatiri failed to stop weapons being distributed to civilians and should face a criminal investigation, a UN inquiry has found.

The probe also accuses two former ministers in Mr Alkatiri's government and the head of East Timor's defence force of creating a "situation of significant potential danger" and recommends that they be held accountable for the illegal transfer of weapons.

The central findings of the report by a three-member panel set up by United Nations Secretary-General Kofi Annan are potentially explosive in a country in which tens of thousands of people are still living in refugee camps, too afraid to return to their homes.

Violence in April and May claimed up to 40 lives and exposed deep divisions in East Timor's army and police.

The army remains loyal to defence chief Brigadier Taur Matan Ruak, one of the heroes of East Timor's independence struggle, despite the report's accusations that he failed to "exhaust all avenues to either prevent or stop" a confrontation between his troops and police.

Fretilin, the ruling party with widespread support in rural areas, will be deeply unhappy with the findings. Mr Alkatiri is still the secretary-general of the party, which he insists he will lead into national elections next year.

The report says Mr Alkatiri's cabinet failed to follow proper procedures when it ordered the army onto Dili's streets, saying that Mr Alkatiri in particular must bear responsibility.

The report accuses army rebel Alfredo Reinado and his men of "having committed crimes against life and the person" during a gun battle on Dili's outskirts on May 23. Major Reinado led a mass escape from Dili's main jail in August and has been holed up in the country's western mountains.

When told of the findings against him, Major Reinado said: "I did not start anything. There was loss of life on my side as well as the other. What am I supposed to do when I am attacked?"

Major Reinado has been holding secret talks with Australian peacekeeping commander Mick Slater about giving himself up. Asked whether the findings would affect the negotiations, he said: "Ask Mick Slater. He's in charge of everything."

The inquiry found that President Xanana Gusmao, the most popular figure in the country, "should have shown more restraint and respect for institutional channels in communicating directly with Major Reinado" after he and his men deserted the army in May. Mr Gusmao is rarely criticised in public.

The inquiry said there was no information before it that could lead to a recommendation that Mr Alkatiri be prosecuted for being personally involved in the illegal distribution of weapons.

But it found there was information "giving rise to suspicion" the he knew about the illegal arming of civilians with police weapons by former interior minister Rogerio Lobato, who is under house arrest in Dili.

The report accuses Mr Alkatiri of failing to use his authority to denounce "credible information" about the transfer of weapons by members of his government.

It found that Mr Lobato and police commander Paulo Martins bypassed institutional procedures by irregularly transferring weapons within the police force. It names Mr Lobato and former minister of defence Roque Rodrigues as having armed civilians along with Brigadier Ruak.

Hundreds of Australian police and troops and other international security forces in Dili were on high alert last night, fearing the report could trigger violence.