Since taking over from Boris Yeltsin, his chaotic predecessor, Mr Putin has made political and economic stability a priority. To this end, he struck a informal deal with Mr Khodorkovsky and other politically powerful businessmen - the so-called oligarchs - who had made their fortunes by winning control of the country's natural resources in controversial privatisations. The president pledged that if the oligarchs stayed out of politics, they could keep their wealth. For the past three years, Mr Putin has kept the agreement. At home and abroad, the conviction grew that Russia was an increasingly predictable place to invest.

But as the oligarchs' wealth soared, a few began to emerge from below the political parapet, especially Mr Khodorkovsky, who did everything from financing political parties to making pronouncements on Russian foreign policy. Mr Putin was certainly annoyed. While the Kremlin has denied that the president explicitly authorised the prosecutors' actions against Mr Khodorkovsky, the crackdown is unlikely to have happened without his prior knowledge. As a former KGB officer, the president is by instinct a defender of state power. But so are most of his bureaucrats, including those in the prosecutor's office.

It was they who launched the investigation that started with Mr Lebedev's arrest for alleged fraud in a 1994 privatisation and was followed by a spectacular raid on Yukos's offices by armed police. The probe has since broadened to include alleged murders and attempted murders in the 1990s. Mr Khodorkovsky is among those who have been called for questioning.

Politically, there is much public support in Russia for attacking oligarchs and redistributing their wealth. Many Russians say the country's 17 dollar billionaires should shift at least some of their money to the 40m poor.

According to a recent opinion poll by Romir-Monitoring, an independent pollster, a majority of Russians say the results of the 1990s privatisations needs to be revised and support criminal prosecution of the oligarchs. Fully 88 per cent believe all big money in Russia has been accumulated dishonestly.

The president's popularity rating has increased by 2 percentage points this month and now stands at 78 per cent. The pro-Kremlin United Russia party has been running neck and neck with the Communist party and the latest events could give it a lead. A public campaign against the country's top oligarch could become a popular re-election card for both the president and his party. "Mr Putin must respect the opinion of his people, particularly before the elections," says a senior Russian official.

But the economic price to be paid for these political gains could be profound, if Russia's emerging reputation for stability is undermined. For the past three years Russia has been enjoying its strongest economic growth in nearly a century. Output rose by a further 7.2 per cent in the first half of this year. After a decade of draining capital overseas, Russian business magnates have started bringing money back from offshore accounts and investing in their own country. Foreign investors are starting to make big decisions, notably BP, the oil group, which this year committed Dollars 6.75bn to a joint venture.

But since Mr Lebedev's arrest on July 2, foreign portfolio investors have been fleeing the market, large foreign direct investors have become nervous and in the past three weeks the Russian market has lost Dollars 20bn, or 13 per cent of its value. Russia's central bank reserves fell Dollars 900m in the two weeks to July 18 - a sign, some economists fear, of renewed capital flight. ING Barings, the Dutch investment bank, says in a report: "With oil prices still high and in the absence of irregular outflows or intervention, reserves should have been up by some Dollars 800m. In other words the net shortfall in reserves is Dollars 1.7bn . . . Our conclusion is that the fall in reserves represents the direct impact of concerns about property rights as a result of the Yukos affair."

Yevgeny Yasin, a former economics minister, says: "The key factor in Russia's growth was not the devaluation of the rouble or even high oil prices but improving the investment climate and the firm belief that the government would not interfere in private business. The action against Yukos suggests a change in a positive trend. If Russian businesses feel uncertainty, the growth will stop."

Stephen O'Sullivan, head of research at United Financial Group, a Moscow-based investment bank, agrees. "The perception is that the risks in Russia are going up. While this may not affect people who are already invested because they have lived with Russia's ups and downs for some time, it will affect people who are thinking of investing in Russia."

Russia's fledgling small and medium-sized businesses are equally concerned about the significance of the Kremlin's move on the oil giant. Sergei Borisov, a representative of SMEs, said recently: "We are certain that the pursuit of big businesses will spread to SMEs. Today they have come for Yukos. Tomorrow they will come for us."

Mr Khodorkovsky must have known for a long time that he was making himself a target. After Boris Berezovsky and Vladimir Gusinsky, the two most politically active oligarchs in the 1990s, were forced out of Russia under Mr Putin, most other oligarchs have tried to keep a low profile and focus on their businesses. One example is Vladimir Potanin, the head of Norilsk Nickel. Another is Mikhail Fridman, who has "insured" himself against political attack by selling half the shares in TNK, his company, to BP.

But Mr Khodorkovsky proceeded on his own, trying to create a huge independent oil company that would be too big to touch. Earlier this year, he launched a friendly takeover of the Sibneft oil company that would make Yukos the largest oil company in Russia and the fourth largest in the world, after BP, Shell and Exxon. He gave money lavishly to charitable causes, including museums, hospital and universities, in Russia and in the west. He financed two liberal parties - Yabloko and the Union of Right Forces - and talked privately of constitutional reform, including replacing the presidency with a parliamentary republic. More significantly, he has acquired influence in the Duma, the influential lower house of parliament, securing a say, for example, in questions on the taxation of natural resources.

This was evident during recent negotiations between Yukos and the finance ministry over tax rates on natural resources. "Khodorkovsky refused any compromises that were offered to him," one senior politician says. "This was not a question of money - what is Dollars 70m a year in oil tax to Yukos? But he wanted to flex his muscles and show how strong he was."

The clearest warning that Mr Khodorkovsky was making himself vulnerable to attack came in December when Mr Putin met a group of Russian business leaders to talk about corruption. Mr Khodorkovsky gave a speech that in effect accused bureaucrats and tax collectors of corruption. Mr Putin's reply was quick and sharp. "I put the ball back in your court," he told Mr Khodorkovsky.

Despite that warning "to shut up and sit down", as one investor puts it, Mr Khodorkovsky continued to confront the Kremlin. He publicly criticised Russia's foreign policy over Iraq, and courted the US political and business elite. This personal foreign policy, however, may have backfired when a senior US diplomat this month expressed his concern about the Yukos affair. "The fact that Khodorkovsky ran crying to the Americans really irritated Putin," one Russian politician observes. "I had never seen him so angry."

Mr Khodorkovsky attained a degree of independence that was unprecedented in Russia and that increasing numbers of bureaucrats could no longer stomach. As Igor Bunin, head of the Centre for Political Technologies, a Moscow think-tank, says: "He started seeking legitimacy not only in the eyes of investors but also in the eyes of Russian society at large. He tried to break out of the old oligarchic circle and started to behave as a businessman of a new formation, independent of the state." o far, the prosecutors' attack has been confined to Yukos. Both Mr Putin and Mikhail Kasyanov, prime minister, have sought to reassure investors that a revision of privatisation is out of the question. But in a country that for most of the 20th century was ruled by fear, a threatening action of this kind has widespread effects. "We are a country with a totalitarian past and as soon as there is a signal to be scared everybody is scared," says Mr Yasin. "Everyone realises that he could be next in line."

Virtually all the oligarchs are vulnerable to similar investigations, because they too have skeletons in their cupboards from the chaotic years of the 1990s. As Mr Yasin puts it: "We don't have angels among the oligarchs."

Kiril Rogov, a Moscow political analyst, says the choice of Yukos, Russia's largest and most powerful oil company, as a target is not accidental.

"The prosecutor's office, and those who stand behind it, had picked on Yukos precisely because it is the biggest, the most powerful and most transparent Russian company, with the largest number of foreign shareholders. It is designed to show that if they can break Yukos and Mr Khodorkovsky, they can break anyone in this country."

Mr Putin's own views on breaking Yukos are unclear. However, since he took office he has been a strong defender of state power. He has re- asserted Kremlin control over Gazprom, the gas monopoly, Russia's most powerful company, retained Sberbank, the state-controlled bank's dominant role in banking, and tried to restrain provincial governors who secured great freedom under Mr Yeltsin. He has also curbed independent television broadcasting.

Within his administration, Mr Putin has promoted former colleagues from the Federal Security Service (FSB, the successor to the KGB) to important posts. It is possible that these men, with their links to the prosecutor's office, are now trying to increase their influence with the assault on Yukos. Lilia Shevtsova, a senior associate at the Moscow Carnegie Centre, a think-tank, thinks so: "The actions of the prosecutor-general's office are evidently the work of the security men eager to reassert their power in the country. Putin must rein them back if he wants to preserve stability."

However, in Mr Putin's administration the influence of the ex-security services men is balanced by a long-serving team of Kremlin officials who worked for president Yeltsin and are still in place, including Alexander Voloshin, the head of the presidential administration, and Mr Kasyanov. Some of these officials have close links with the oligarchs. The president is also served by a team of free-market oriented reformers, such as German Gref, the economy minister.

For the moment, if Ms Shevtsova is right, the former KGB men have the upper hand. But much depends on how far Mr Putin chooses to let them pursue Mr Khodorkovsky.

Some good may yet come from the conflict. Mr Putin may decide that once the prosecutors have given the oligarchs a good fright, they may become more willing to accept at least some wealth redistribution, for example through tax reform. Many Russians would like to see the rich paying higher taxes to help tackle poverty and under-investment in public services. Some oligarchs may decide that higher taxes could be a price worth paying for greater social stability.

If Russia is to make a transition into a fully functioning market economy, it must reduce the concentration of capital in oligarchs' hands by encouraging entrepreneurs and foreign investment. Grigory Yavlinsky, leader of Yabloko, says: "Oligarchy is a real problem for Russia and has a colossal negative impact on the economy. The system must be dismantled - but not by destroying the investment climate."

But there are serious political dangers in the way the authorities have pursued Yukos. The officials responsible for the attack have demonstrated that the state in Russia will share its political powers with independent forces unwillingly, if at all. As Mr Yasin says: "We have never had businesses independent of the state in this country. Yukos is just one example of a struggle between private business and the state. But the state will always win, because it has the army on its side."

The state's hand is greatly strengthened by the fact that Russia's economic wealth is based on natural resources, which lend themselves to central control. Many countries have struggled to develop genuinely liberal market economies on such a basis - or genuine multi-party democracies.

See also:

YUKOS Case

Financial Times (UK), July 31, 2003