Millions of insurance policyholders could be denied thousands of pounds each in windfall payments following a judgement by the Financial Services Authority (FSA), the City watchdog, on a £14 billion surplus held by insurers.

Which?, the consumer group, said British insurers including Norwich Union and Prudential would be able to use landmark guidance from the FSA to withhold as much as £8.4 billion in payouts from their with-profits funds.

Dominic Lindley, Principal Policy Adviser at Which?, said the group was considering taking legal action to protect policyholders' interests and urged Norwich Union and other insurers to give customers a fair deal.

"We are calling on the insurers to act with integrity, rather than to try to exploit weak FSA rules to grab as much as they can," he said.

Legally insurers have no obligation to return the surplus, which has built up over a number of years, to policyholders.

Which? tried unsuccessfully seven years ago to try to secure a better deal for policyholders in Axa's £1.7 billion fund. In the end, the French insurer paid out just 31 per cent of the fund's value.

A letter to Clare Spottiswoode, the advocate for up to one million policyholders in Norwich Union's £5.4 billion fund, showed that the FSA had barely altered guidance on the issue it put in place three years ago.

The regulator said insurers can use the surplus in their funds to subsidise new business, pay tax on distributions to shareholders, traditionally covering 10 per cent of a fund, and finance strategic investments.

The FSA said it would review its affirmation that insurers could use surplus funds, often termed the inherited estate, to pay for claims they missold policies.

Ms Spottiswoode described the the FSA's judgement as "very disappointing" and said it unfairly benefited shareholders.

According to consumer groups, it effectively means that insurers can ringfence hundreds of millions of pounds each year rather than consider them as part of a potential policyholder return.

It applies to all UK insurers holding with-profits funds. Together, the Pru and Aviva, which owns Norwich Union are sitting on an inherited estate worth about £14.1 billion. The Pru has about 4.5 million with-profits policyholders and a fund surplus of about £8.7 billion.

The Pru has delayed providing an update on its decision about whether to offer to reattribute the assets until the middle of next year. Other insurers including Standard Life and Legal & General are considering deals whereby they return surplus fund to policyholders.

In a reattribution, the insurer retains the excess capital and pays a sum to each policyholder in exchange for forgoing the right to a payout if the fund is closed later. Payouts vary depending on the size and maturity of a policyholder’s fund.

Stephen Mann, executive director of Norwich Union Life, welcomed the FSA's ruling and denied that customers would be unfairly treated.

"We really welcome it. It removes a major obstacle in being able to put forward proposals to customers. We are very commited to ensuring they have as much information as possible in order to ensure they can decide whether they elect to receive a payment or not," he said.

Mr Mann said Which?'s reaction was "a bit misplaced" and suggested that Norwich Union might have abandoned the idea of a reattribution if the FSA had decided to change the rules.

Norwich Union sent out guidance today on which policyholders might qualify for a payment.

The FSA defended its guidance, put in place in 2005 following a full round of consultation, and denied it had missed an opportunity ahead of a payout at Norwich Union that could come as early as next summer. It also pointed out that it would be consulting on the issue of mis-selling.

Sarah Wilson, director of treating customers fairly and the FSA's insurance sector leader, said: "No, we don't think that policyholders lose out by the announcement. We have not made a new ruling. We've reaffirmed a brand new set of circumstances.

"We have looked very carefully at the points that have been put to us. We are confident that these rules are absolutely fair to policyholders."

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