One of New Zealand's key intelligence agencies has suspended operations with the country's law enforcement agencies after admitting it illegally intercepted the communications of a German millionaire wanted by US authorities.

Prime Minister John Key on Thursday released a report by Inspector-General of Intelligence and Security Paul Neazor into the unlawful interception of executives of the file-sharing website Megaupload, who are wanted by the US on charges relating to alleged copyright violations and money-laundering.

Key said the report and his own discussions showed the illegal interceptions by the Government Communications Security Bureau (GCSB) were a result of human error.

Under New Zealand law, the GCSB is prohibited from intercepting the communications of New Zealand citizens and permanent residents, but it failed to carry out its own checks on the residency status of Kim Dotcom and a fellow Megaupload executive.

"First, the GCSB originally relied on the Police's information about the residency status of the people in question. They did not check further," Key said in a statement.

"Second, this error was compounded after the operation was concluded by a simply wrong interpretation of the law."

Neazor's report had noted the potential for confusion between the relevant agencies about changes to the Immigration Act in 2009 and the subsequent effect on the GCSB legislation.

At the time in question, Kim Dotcom held a residence class visa, but it was not interpreted by the Police or GCSB that he fell into the protected category of permanent resident.

"The GCSB relied on information provided to it by the Organised and Financial Crime Agency New Zealand. In my view, reliance on another party by GCSB is unacceptable," said Key, who is the minister responsible for the GCSB.

"It is the GCSB's responsibility to act within the law, and it is hugely disappointing that in this case its actions fell outside the law. I am personally very disappointed that the agency failed to fully understand the workings of its own legislation."

Key said the GCSB would be reviewing cases of communications interceptions back to 2009 when the Immigration Act was changed, and would report to the Prime Minister and the Inspector-General as soon as possible.

The GCSB had also halted operations in support of the Police and other law enforcement agencies while new approval processes were established.

GCSB director Ian Fletcher issued a public apology Thursday for its part in the Dotcom case.

"I am very sorry for the way the bureau has handled its part in the Dotcom case. I have apologized on behalf of the Bureau to the Prime Minister and the Deputy Prime Minister, and the Prime Minister's own statement has made clear his views," Fletcher said in a statement.

"We got this wrong. Both factual errors and unacceptable errors of legal interpretation were compounded, most especially by our treating those interpretations as fact for too long. It should not have happened."

The GCSB would be fundamentally overhauling its compliance framework to tighten processes significantly, as well as carrying out an internal audit to identify changes that were needed, he said.

"I know that it will take time to regain the trust and confidence that we have lost. But I also know that we will be able to do so, and be able to re-establish the high standard of accountability expected of us."

The illegal spying scandal is the latest in a string of mistakes by the New Zealand authorities in their cooperation with the United States to bring a case against Dotcom and three other Megaupload executives.

The extradition case, originally scheduled for August, has been delayed until March next year after becoming entangled in legal arguments, appeals and critical judgments.

In June, a New Zealand judge ruled that the country's police acted unlawfully in allowing the US Federal Bureau of Investigation (FBI) to copy computer data seized from Dotcom and remove it from the country, and that the warrants used by police to raid Dotcom's Auckland home and to seize property on behalf of the FBI were illegal.

Other points of legal contention revolve around how much evidence, including more than 22 million e-mails, the New Zealand prosecutors acting on behalf of the US authorities are required to disclose to Dotcom's legal team.

In March, the US Department of Justice formally lodged an application for the extradition of Dotcom and the other Megaupload executives from New Zealand on charges related to Internet piracy.

Although the United States and New Zealand have an extradition treaty, New Zealand courts could refuse to hand over Dotcom and his co-accused, Mathias Ortmann, Bram van der Kolk and Finn Batato.

New Zealand Police arrested Dotcom in Auckland on January 20 at the request of the US Justice Department and the FBI on charges including copyright infringement, wire fraud, money laundering and racketeering.

Dotcom spent a month in prison before being allowed bail to live with his heavily pregnant wife and three children.