Home Secretary Jacqui Smith has ditched plans for a giant Government database tracking all emails, phone calls and internet activity.
Ms Smith said a central store of electronic data was an "extreme" solution and would have undermined privacy.
Records of every electronic communication made by Britons will instead be held by private companies at a cost of around £2 billion.
Internet firms will be asked to collect and store vast amounts of data, including from social networking sites such as Facebook.
Launching the proposals, Ms Smith acknowledged concerns over privacy.
She said: "My key priority is to protect the citizens of the UK, and communications data is an essential tool for law enforcement agencies to track murderers and paedophiles, save lives and tackle crime.
"Advances in communications mean that there are ever more sophisticated ways to communicate and we need to ensure that we keep up with the technology being used by those who would seek to do us harm.
"It is essential that the police and other crime-fighting agencies have the tools they need to do their job. However, to be clear, there are absolutely no plans for a single central store.
"We recognise that there is a delicate balance between privacy and security, but to do nothing is not an option as we would be failing in our duty to protect the public."
Under the plans, every internet user will be given a unique ID code and all their data stored in one place. Government agencies such as the police and security services will access the data to investigate suspected criminals and terrorists.
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