FirstGroup have been told they will no longer be given the franchise for the West Coast Main Line as planned after "completely unacceptable mistakes" in the bidding process.
UK Transport Secretary Patrick McLoughlin made the announcement late on Tuesday and said two independent reviews into the competition process.
Aberdeen-based FirstGroup were due to take over operation of the service on December 9, taking over from Virgin Rail.
They were awarded the contract by the Department for Transport (DfT) in August and Virgin launched a High Court challenge against the decision. The department said it would be no longer contesting the judicial review sought by Sir Richard Branson's company.
Since the decision was announced, FirstGroup's shares have dropped by 30%, wiping £230m from their market value.
Meanwhile, Scottish transport minister Keith Brown said the situation was "shambolic" and wanted to know why the Scottish Government had not been told of the problems earlier.
Mr McLoughlin said the problems relate to the way procurement was conducted by department officials, and announcement is expected later on Wednesday about suspension of staff.
He said: "I have had to cancel 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.
"A detailed examination by my officials into what happened has revealed these flaws and means it is no longer possible to award a new franchise on the basis of the competition that was held.
"I have ordered two independent reviews to look urgently and thoroughly into the matter so that we know what exactly happened and how we can make sure our rail franchise programme is fit for purpose.
"West Coast passengers can rest assured that while we seek urgently to resolve the future arrangements the trains that run now will continue to run, with the same drivers, the same staff and timetables as planned.
"The tickets that people have booked will continue to be valid and passengers will be able to make their journeys as planned."
Officials have now been asked to examine the options for the operation of the service after December 9.
An investigation, carried out as staff prepared for Virgin’s High Court action, showed there were mistakes in the way the level of risk in the bids was evaluated. Errors were made in the way inflation and passenger numbers were taken into account and how much money bidders were then asked to guarantee.
The Government said a fresh competition will be started as soon as "the lessons of this episode are learned".
FirstGroup said that until it was notified by the DfT last night, it had no indication there were any problems with the franchise process.
The firm said: "Until this point we had absolutely no indication that there were any issues with the franchise letting process and had received assurances from the DfT that its processes were robust and that it expected to sign the contract with FirstGroup soon.
"We are extremely disappointed to learn this news and await the outcome of the DfT's inquiries. The DfT has made it clear to us that we are in no way at fault, having followed the due process correctly.
"We submitted a strong bid, in good faith and in strict accordance with the DfT's terms."
Mr Brown said he was annoyed they had not been told about the decision.
He said: "I am calling for an urgent meeting with the UK Transport Secretary, and currently trying to make contact by telephone, and will be demanding an explanation of the impact of this decision for Scotland's rail users. This is a shambolic situation that affects thousands of passengers in and out of Scotland.
"I will do everything I can within our current limited powers to help minimise any uncertainty and disruption for them and I urge the Department for Transport to sort out this horrendous mess and do the same. Despite the fact that this franchise provides services to and from Scotland, we were not advised of the findings nor of the fact that they would be announced today and therefore not included in planning how best to protect the interests of Scottish passengers.
"I have repeatedly raised concerns with the UK Government about the operation of franchises and sought full responsibility for the Scottish Parliament. This is further evidence of why Scotland needs full responsibility for its own rail services with the powers of an independent parliament."
Virgin said it would assist the DfT by continuing to run the service while the independent reviews are conducted.
It said in a statement: "We welcome today's frank announcement by the secretary of state, acknowledging the flaws in the way the InterCity West Coast competition was assessed and launching a review into franchising more widely.
"We are ready to play a full part in assisting the review to help deliver a franchising system that better serves passengers, taxpayers and the interests of all bidders.
"In the meantime, we will assist the Department for Transport in ensuring continuity of service for the millions of customers who depend on train services on the West Coast mainline."
The franchise was due to operate for a core term of 13 years and four months with an option to be extended to operate for up to 15 years.