Controversy over the extradition of a priest who allegedly worked for the IRA left Anglo-Irish relations "at the bottom of the pit".
Fr Patrick Ryan was at the centre of a lengthy legal battle in the late 1980s.
The Tipperary-born former Pallottine priest was said to be quartermaster for an IRA unit operating in Belgium.
In June 1988, two months after the murder of three off-duty British servicemen in the Netherlands, Belgian police arrested Fr Ryan and found large quantities of cash and bomb-making equipment in his home.
While he embarked on a hunger strike, the Government attempted to have him extradited from Belgium. But the authorities sent him back to Dublin, where he was at the centre of a diplomatic row.
New details of the controversy emerged in papers released by the Public Record Office of Northern Ireland.
In a memo sent in late 1988 the British Ambassador to Dublin said the affair had undone months of progress.
Sir Nicholas Fenn wrote: "Until 25 November it seemed that we were making progress in digging ourselves out of the pit into which we had fallen at the beginning of the year. Then Patrick Ryan was hurriedly repatriated from Belgium.
"The Irish failed to arrest him. The resulting British anger provoked defensive resentment in Ireland."
After a formal request for his extradition was lodged in Dublin, Margaret Thatcher effectively called the priest a terrorist.
She told the Commons: "The failure to secure Ryan's arrest is a matter of very grave concern to the Government.
"It is no use governments (of Belgium and Ireland) adopting great declarations and commitments about fighting terrorism if they then lack the resolve to put them into practice."
In December 1988 then Taoiseach Charles Haughey told the Dail the serious charges levelled against Ryan should be investigated by a court in Ireland.
He claimed that prejudicial remarks made in the House of Commons meant the priest could not expect a fair trial in Britain.
Sir Nicholas wrote: "British opinion was insulted, and we were back at the bottom of our pit. We have now decided to seek extraterritorial prosecution if the witnesses can be mustered; half a loaf is better than no bread."
In October 1989 the director of Public Prosecutions in the Republic announced that he had decided not to initiate proceedings against Ryan. The affair led to heated discussions at the Anglo-Irish intergovernmental conference in Belfast, where there were angry exchanges between then Secretary of State Tom King and Irish foreign affairs minister Brian Lenihan.