A government study has found a "lack of clear correlation" between tough drug laws and levels of drug use.
The study compared the UK's drugs policy to 13 other countries including Portugal, where it is no longer a criminal offence to possess a small amount of drugs.
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Since Portugal made drug possession a health issue rather than a criminal issue in 2001, there has been a "considerable" improvement in the health of drug users, said the report.
Sources told the Daily Telegraph that the findings had caused "panic" within the Home Office, and triggered a row between Tory Home Secretary Theresa May and Liberal Democrat Home Office minister Norman Baker.
In the Lib Dems' 2010 election pledge, the party promised a royal commission to examine the alternatives to the current drug laws, and Baker has argued that locking people up for taking drugs does not necessarily change their drug habit.
"If we're interested in changing people's behaviour then we need to look at it from a health point of view," he said.
BBC home affairs correspondent Danny Shaw says Baker's views are "at odds" with the official Home Office position, which says the current drug strategy is working.
The department has swiftly issued a statement to confirm that it has "absolutely no intention of decriminalising drugs".
Danny Kushlick, founder of the Transform Drug Policy Foundation, described the report as a "historic moment" for UK drug policy.
"For the first time in over 40 years the Home Office has admitted that enforcing tough drug laws doesn't necessarily reduce levels of drug use," he said. "It has also acknowledged that decriminalising the possession of drugs doesn't increase levels of use."
The report has overshadowed a separate government plan for a blanket ban on all brain-altering drugs in a bid to tackle legal highs.