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Deal: Gibraltar has been a British overseas territory since 1704
The former Europe Minister revealed Mr Blair sanctioned the deal because he wanted to win the backing of the Spanish government – then led by Jose Maria Aznar – to help Britain take on France and Germany in EU negotiations.
The agreement was only shelved when what he called 'hardliners' in the Spanish government – who wanted only full sovereignty – objected.
In Outside In, published yesterday, Mr Hain says he joined forces with then Foreign Secretary Jack Straw to make private overtures to Spain during 2001.
Mr Hain and his Spanish counterparts looked at an 'Andorra solution' which would have seen co-sovereignty between the UK and Spain.
In February 2002, Mr Hain says he was given the green light by Mr Blair to proceed.
He quotes Mr Blair as saying: 'It is really important to get a better future for Gibraltar, to secure a better relationship with Spain and to remove it as an obstruction to our relations within Europe.'
But Gibraltar's first minister Peter Caruana told Mr Hain: 'There is no prospect of me agreeing with such an approach.'
Mr Hain accused Gibraltarian leaders of being 'stuck in the past'.
The deal unravelled with Spain's 'conservative, nationalist government getting cold feet at the last moment', he says. Mr Blair then urged him to 'park' the agreement.
Gibraltar then held a referendum in which 98.48 per cent voted No to a deal with Spain.
Labour's willingness to sell out the people of Gibraltar stands in contrast to the firm line taken by the Coalition. David Cameron has repeatedly said Gibraltar should stay British.
A spokesman for Mr Blair said: 'Tony Blair has never said or thought Gibraltar should be “run by Spain”. Nor was he “contemptuous” of it.'