The British Ministry of Defence has rejected a request from the Foreign Office to hand over £400 million (Dh1.86bn) owed by the UK government to Iran from a British tank sale in 1976.
The department said it was not prepared to provide the money for the deal, which ended with the revolution in Iran, to the Islamic Revolutionary Guard Corps.
An international arbitration court has ruled that the money should be transferred, The Guardian reported.
But ministerial sources say UK defence secretaries have, over the years, opposed the move because they believe it would end up in the hands of the IRGC, which is causing insecurity in the Gulf region.
Sources said that if the money were transferred, jailed British-Iranian woman Nazanin Zaghari-Ratcliffe would probably be released, although Tehran has not publicly linked the two outcomes.
The UK and Iran put their legal arguments about the payment to a high court hearing last week.
Over the weekend, British newspaper The Sunday Times won a court order allowing the arguments in the case to be published, a move welcomed by Ms Zaghari-Ratcliffe.
The documents show Tehran had asked the British Treasury to approve the payment from a government-owned defence company to the Central Bank of Iran.
Iranian officials believe the payment can be made without breaching EU sanctions.
In January, Britain, Germany and France set up a European system to enable non-dollar trade with Iran, circumventing US sanctions against the nation.
But US Secretary of State Mike Pompeo has been critical of the EU-backed “special purpose vehicle”.
Despite the sensitive nature of the case, British Foreign Secretary Jeremy Hunt said there had never been a government policy to keep the court hearings private.
Mr Hunt said it was normal legal practice for such arbitration cases to be held in private.
He likened the handover of the debt to paying a ransom.
"The problem is, if you pay ransom money to someone who is a hostage then all that happens is you might get that hostage out," Mr Hunt told the BBC's Today show.
“But the next time they want something they’ll just take someone else hostage. That is the conundrum we have.”
Ms Zaghari-Ratcliffe’s supporters said his description of the payment as ransom was surprising given the government acknowledges that a payment is owed.
She was detained in Iran in 2016 on espionage charges, which she denies. Her husband revealed this year that she had been asked to spy on the UK in exchange for her freedom.
This month Aras Amiri, a British Council employee in London, was sentenced to 10 years in prison in Iran after being accused of spying for the UK.
Ms Amiri and Ms Zaghari-Ratcliffe are being held in Tehran’s notorious Evin Prison.
After the arrest of several British-Iranian citizens in Iran, the Foreign Office warned dual nationals against all travel to the country.