A whistle-blower's lawsuit against alleged contract fraud in Iraq can continue, but the U.S. government lacks the authority to police the spending of billions of dollars of Iraqi oil money, a federal judge in Alexandria has ruled.

The decision in the case involving Fairfax security firm Custer Battles LLC was issued yesterday by U.S. District Judge T.S. Ellis III. The ruling was the first to decide how far the federal False Claims Act can be stretched to cover alleged theft in contracts on the battlefield.

Two former employees had sued Custer Battles over the company's work on two contracts in Iraq. One contract was to provide security to Baghdad International Airport and another was for helping move new currency around the country. The workers claimed the company used shell companies in the Cayman Islands and elsewhere to submit phony bills to the U.S.-led Coalition Provisional Authority, which ran Iraq for the first year after the war.

If the authority were an American agency, there would be little question that the whistle-blowers could pursue their suit under the Fair Claims Act, Ellis said. But because "the essential nature" of the CPA is "shrouded with ambiguity," he ruled, the case depends on the origins of the money at the heart of the allegations.

The judge noted that aid used in rebuilding Iraq came from four sources: U.S. funds appropriated by Congress, "vested" Iraqi funds seized by the United States, "seized" Iraqi funds -- mostly cash -- uncovered by coalition forces occupying the country, and funds from the Development Fund for Iraq.

It was the last pot of money that Ellis said could not be reached by the federal fraud law. DFI funds included those from the sale of Iraqi oil after the war, transfers from the United Nations oil-for-food program and international donations. But Ellis said the whistle-blowers can continue their suit because they contend that not all of the money in question came from the DFI.

Steven L. Schooner, a contract law expert at George Washington University law school, said the message is that the courts will oversee fraud claims if U.S. tax funds are involved, but "if it's someone else's money, too bad."

He added: "On one level it is an incredibly ugly result, but probably legally proper. If I were a donor country I wouldn't be amused by this."

Alan Grayson, attorney for the former Custer Battles employees, said Ellis's ruling was a positive one for his clients because they can pursue their claims. "But it's a pretty bad day for the American taxpayer, and a pretty good day for war profiteers," he said, because the decision means the spending of billions in Iraqi funds will not be covered by the False Claims Act.

Richard Sauber, the lawyer for the company, did not return a call seeking comment. Custer Battles spokesman Jake Dye was quoted by the Associated Press as saying the company welcomed the chance to have a forum to prove it did nothing wrong and that the former employees conspired against it.

The Justice Department filed a brief in the case, at the judge's urging, in which it argued that the CPA was a government entity and that Ellis should take a more expansive view of the law. DFI funds should be included within the reach of the fraud law because the U.S. government was responsible for the Iraqi funds, government attorneys said.