A fire blazed in the hearth, decorations were all about and a quartet of carolers lent a festive air when Marine Sgt. Clayton J. Lonetree walked up to the CIA chief of station at a Christmas party at the U.S. ambassador's residence in Vienna on Dec. 14, 1986. "I'm in something over my head. I need to talk to you about it," the Marine security guard said to the intelligence veteran.

That brief and surprising statement set off an espionage investigation that erupted dramatically into a sex-for-secrets scandal in early 1987. Within months, Lonetree became a central figure in a security disaster in which, it was charged, he and other guards permitted Soviet KGB agents to roam at will through the U.S. Embassy in Moscow.

The government has concluded, however, that the entire affair was wildly overblown. The Navy still believes it has uncovered a serious security problem in worldwide Soviet efforts to subvert Marine security guards, but the most serious and sensational charges made last year have all but collapsed. No evidence has been found to confirm that the KGB penetrated the Moscow Embassy. And new information indicates that the investigation was mishandled.

But the facts may never catch up with the sensation created last spring. In March, the government charged Lonetree and another former Marine guard, Cpl. Arnold Bracy, with conspiring to bring Soviet agents into the most sensitive portions of the U.S. Embassy in Moscow in predawn forays, exposing to Soviet scrutiny the top-secret communications center and the special "bubble" room for highly classified official conversation.

Amid the shocking disclosures, the Moscow Embassy was ordered to cease all classified communication with the outside world and to shut down processing of all classified information on computer terminals, electric typewriters and even manual typewriters on the theory that they might have been programmed by nocturnal KGB visitors to emit telltale electronic pulses.

Embassy officers spoke in whispers and wrote messages to Washington in an often illegible longhand, to be hand-carried out of the Soviet Union by a courier in a daily diplomatic pouch. Two members of the House Foreign Affairs Committee took childrens' Magic Slate pads on an inspection trip to Moscow, saying that they had been told they were the only secure means of communicating in the embassy.

For the first time in history, the entire 28-man Marine Security Guard detachment was replaced as the investigation mushroomed. President Reagan, in a special appearance before the news media and in a radio address, condemned the security breach and announced investigations to deal with it and the unrelated issue of suspected Soviet bugging of the still-unfinished new U.S. Embassy building in Moscow. The problem with the new U.S. Embassy persists with no solution in sight.

Bureaucratic warfare broke out when Navy Secretary James H. Webb Jr. publicly accused former U.S. ambassador to Moscow Arthur A. Hartman of being partly responsible for the Marine security "scandal." Hartman replied that Webb was "talking through his hat." Secretary of State George P. Shultz was so infuriated by Webb's accusation that he issued instructions that the Navy secretary not be permitted in the State Department building, according to a senior department official.

In April, a specially equipped communications van was flown to Moscow to make possible confidential reports to Washington during Shultz's two-day visit at a critical point in the intermediate-range nuclear forces (INF) negotiations. Declaring that he would lodge a sharp protest about the KGB penetration while in the Soviet capital, Shultz said at a news conference, "They invaded our sovereign territory, and we're damned upset about it."

When Shultz took up the issue in Moscow, however, Soviet Foreign Minister Eduard Shevardnadze bluntly replied, "Mr. Secretary, you are being deceived."

Last April was the high point of the "sex-for-secrets" scandal and the low point for the Marines and the U.S. Embassy in Moscow. But bit by bit in the months that followed, "confessions" were repudiated, some of the most serious charges were dropped for lack of corroboration, physical evidence from a variety of sources tended to conflict with the allegations and doubts grew about the nature and extent of the "security disaster" in Moscow.

Today, after extensive damage to the embassy's ability to function and after spending many millions of dollars to bring home and replace its sensitive equipment, the U.S. government organizations most directly involved have decided that Lonetree did not conspire with Bracy to bring Soviets agents into the Moscow Embassy after all.

"Our judgment today is that Lonetree gave them {the Soviets} some information, but it was not as sensitive as we originally believed. There were no Russians in the secure parts of the building where Russians shouldn't be," said Robert E. Lamb, chief of the State Department's Bureau of Diplomatic Security.

In Moscow, a recent visitor quoted U.S. Ambassador Jack F. Matlock as having described the situation more succinctly, terming the alleged KGB penetration of the embassy "a nonoccurring event."

Even the Naval Investigative Service (NIS), which developed and may have bungled the case, has concluded after painstaking "damage-assessment" interrogations of Lonetree last November that he never brought Soviets in nor helped others to do so. The interrogations were conducted under carefully controlled conditions following Lonetree's Aug. 21 court-martial conviction, and 30-year prison sentence, for passing some secrets to the Soviets.

NIS continues to have unresolved questions about Bracy, but Navy officials concede it would have been "difficult to impossible" for one Marine working alone to arrange and carry out a KGB penetration.

In the State Department, the "KGB-in-the-Embassy" scandal of 1987, which threatened to disrupt U.S.-Soviet relations as they were improving after a long chill, was reminiscent of the "Soviet-brigade-in-Cuba" affair in the fall of 1979, when the SALT II strategic arms limitation treaty was pending in the Senate.

In both episodes, top government officials, including the president, were embarrassed and gravely concerned about a suddenly perceived threat to U.S. national security. And in both cases, when the dust had settled, the government had been grappling mostly with phantoms of its own invention.

The revelations that touched off the Moscow Embassy affair followed a hemorrhage of espionage losses due to recruitment by the Soviets of an FBI agent (Richard W. Miller), a former National Security Agency official (Ronald W. Pelton), a man trained to be a Central Intelligence Agency operative in Moscow but let go (Edward Lee Howard), and a Navy family (John A. Walker, his brother and son) the recruitment by Israel of an NIS analyst (Jonathan Jay Pollard), and the loss of some intelligence assets in the Soviet Union.

The Marine spy charges came after years of unconfirmed suspicions by some U.S. counterintelligence officers that Soviet agents must somehow be penetrating the U.S. Embassy in Moscow. One theory, which proved groundless, was that the KGB had employed "greased dwarfs" to invade the secure portions of the embassy through heating ducts.

Against this background, the sensational charges about the U.S. Marine guards "seemed to provide all the explanations" to the security controversies of the past, former ambassador Hartman said in a recent interview. "The psychological atmosphere was such that nobody wanted to say, 'No, this might not have happened.' That would have been a sign of complacency." In fact, nobody of prominence in any part of the government voiced strong and open skepticism, despite considerable evidence that the incredible tale had some serious flaws.

The episode began when Lonetree, 25, an American Indian, confessed to the CIA officer that he had cooperated with the KGB secret police agents in Moscow, where he had been stationed from September 1984 to March 1986, and in Vienna, where he was stationed at the time of his confession.

Lonetree's initial admissions to the CIA and the NIS were that he had been recruited through a sexual relationship with a Soviet employee of the embassy and that he had provided the names of some CIA officers on the Moscow and Vienna Embassy staffs as well as floor plans and office assignments in those embassies. The recent interviews with Lonetree have validated these initial statements, but not other charges of a much more far-reaching nature.

Navy sources said that shortly after Lonetree's confession, the decision was made to assign the case to the civilian investigators of the NIS, which has a checkered record of performance and which was kept on the fringes of the earlier spy cases. The NIS began interviews with current and former Marine guards from the Moscow and Vienna embassies to verify Lonetree's statements and probe for further breaches of security.

Strangely, for more than three months nobody interviewed Bracy, 21, a native of New York City, who had been relieved of duty in the Moscow Embassy, fined and reduced in rank from sergeant to corporal in the late summer of 1986 after acknowledging unauthorized contact with a female Soviet employee. Frederick A. Mecke, the senior security officer at the Moscow Embassy who decided to send Bracy home, had sent a cable to Washington in August 1986 mentioning the possibility of espionage and asking that it be followed up. But nothing was developed, according to Assistant Secretary of State Lamb.

After receiving a variety of NIS investigative reports in Moscow early last year, Mecke realized that nothing was being said about Bracy. On March 9, he sent another cable recommending again that Bracy be interviewed. For reasons unknown, this cable never reached NIS, according to Navy sources.

On March 16, the CIA officer who had interviewed Lonetree the previous December in Vienna remarked to an NIS agent in the Austrian capital that Lonetree had identified Bracy as his best friend in Moscow. Somehow the CIA officer had neglected to mention this in his earlier investigative reports.

Finally, Bracy got NIS's attention. On March 17, a three-page "operational immediate" NIS telegram landed at the NIS office at 29 Palms, Calif., where Bracy was stationed. The investigators were told about Bracy's alleged fraternization in Moscow and relationship with Lonetree and instructed to interrogate and polygraph Bracy and report back within 72 hours.

Bracy was interrogated for three days by NIS agents in nearby motels starting March 18.

The first day Bracy described his guard duties and what he knew of Lonetree and denied knowledge of espionage.

The second day, after more intense and hostile questioning, Bracy signed a statement acknowledging that he had sexual relations with the Soviet woman, which he had denied up to that point.

The third and crucial day, March 20, gave rise to a six-page, single-spaced, typewritten statement replete with rich detail of how Bracy first observed and then joined Lonetree in arranging the surreptitious entry of Soviet agents to the communications center, CIA headquarters and other supposedly secure parts of the embassy on numerous occasions between midnight and dawn in early 1986.

In this convincing statement, which was the smoking gun of the Marine scandal and which has never been made public, Bracy declared, "I knew I was not the main actor, but I was involved in espionage against the United States by cooperating with Lonetree in letting Russians into the chancery building and not reporting what they and he were doing." This statement, written and typed by NIS agents, was in effect a plea of guilty to an offense that carries the penalty of death under U.S. law.

The circumstances of this statement are hotly disputed. NIS insists that an investigation has shown it to have been obtained in good faith and with proper procedural safeguards by a senior NIS agent, who is a former vice squad policeman from Honolulu, and two experienced NIS polygraph operators who also acted as interrogators. The use of polygraphers as interrogators is unusual and questionable, according to Bracy's attorneys.

Bracy said later that in an exhausting nine-hour ordeal, the agents continued to insist that he speculate on "a scenario, a story that was cooked up," under which Soviets could have entered the embassy with Lonetree's help, and that the agents wrote up his responses as if they were fact.

"They kept saying that they felt these things were possible, and I kept telling them no," recalled Bracy, who insisted that he was threatened into signing the statement without being permitted to read it.

There is no dispute that, within a few minutes of signing the statement, Bracy began insisting vehemently that it was untrue. Such behavior is not uncommon among those who have made incriminating statements. But this instant repudiation was not reported to Washington officials at the same time as Bracy's explosive "confession," according to people in high posts at the State Department and Marine Corps headquarters.

Under usual procedure for investigators at NIS and elsewhere, any changes or corrections to a written statement should be initialed by the subject before signing. In fact, the final paragraph of Bracy's March 20 statement says that "I have read this statement and initialed in ink all the corrections I desire to make." But despite typographical or other errors on five of the six typed pages, and one change made in handwriting, there are no initials by Bracy or anyone else in the text. This suggests he did not read it carefully, if at all.

Some aspects of the Bracy "confession" conflict with easily checked facts, but this does not appear to have been done at the time. The log books kept by Marine security guards in Moscow had been turned over to NIS when the Lonetree case broke. According to the logs, Bracy and Lonetree never worked together at night during the period of their alleged conspiracy in the two guard posts that Bracy repeatedly described in his statement. The NIS did not discover this until much later, and then argued that the logs might have been inaccurate or tampered with.

Some of Bracy's explanations of how alarm systems in the embasssy were evaded or disabled were "just false," according to Lamb. "There were things that could not have happened." For example, "there are sophisticated devices which would preclude a Marine or you and me from entering that communications center," but these were not mentioned in Bracy's statement, Lamb said.

A later close examination of those devices showed no sign of any unauthorized entry to the communications center, as alleged by Bracy, or any sign of attempted tampering with the devices.

All the communications equipment in the Moscow Embassy and the secure "bubble" have been examined almost microscopically since being replaced and hastily shipped out of the Soviet Union. So far, according to Lamb, no eavesdropping devices or other clearcut signs of tampering have been found, although the study is still incomplete.

In defense of Bracy's statement, NIS now points out that it was accepted as credible evidence by Marine legal officers in the subsequent proceedings against Bracy. However, the top command of the NIS is currently convinced that Lonetree did not collaborate with Bracy, according to Navy sources. A senior NIS official has said of the March 20 Bracy statement, "you could take Lonetree's name and cross it out" wherever it appears. This would leave little else in the document.

Bracy's statement was cabled to Washington via secure facilities immediately after it was signed, and showed up on the desks of senior U.S. officials in highly classified form the next day, March 21. The report that there were two traitorous Marines, who had worked together to permit Soviet agent access to the innermost secure rooms of the Moscow Embassy, was a bombshell.

Top officials of the White House, State Department, Marine Corps, CIA and other agencies met in crisis atmosphere to deal with what appeared to be one of the most serious security breaches in history. On March 25, the State Department ordered the embassy to cease all classified communication and processing of all classified information.

Nearly everything of major importance that the Moscow Embassy does or reports is classified. "If the Soviets had wanted to shut down the most important eye on their operations, they could not have done it better than we did it to ourselves," said an official who was stationed at the embassy at the time. "At a very serious time, we took the one eye we had and poked a stick into it."

The NIS was suddenly plunged into the largest espionage investigation in its history by the shocking Bracy disclosures. A large task force, code-named "Bobsled," was organized and more than 100 NIS invesigators were set to work on the Marine case. As of last week, the Bobsled task force -- which is still active -- had interviewed 482 Marine security guards and 1,261 other individuals in 35 countries, and administered 259 polygraph examinations.

The investigation and legal preparation of a major espionage case typically consumes 18 months, according to Navy officials. But in the Marine guard case, the NIS was bound by very short deadline of 90 days between arrest and trial dictated by the Uniform Code of Military Justice. In retrospect, haste may have caused some of the most serious flaws in the NIS investigation. By the time of Bracy's third statement, the 90-day period for Lonetree had almost expired.

On March 27, NIS headquarters sent an urgent cable to its worldwide staff. It began, "President Regan {misspelled in the cable} has been briefed on this case, expressed concern and requested frequent updates. As such, this investigation takes priority over any matter now being handled by NIS and must be responded to accordingly."

A White House official said last week that while Reagan was kept informed of the reports, there was no presidential directive as suggested by the memo. Navy officials familiar with the details of the case conceded that citing presidential authority to field investigators was "probably a little overreaction," but also said that, due to the 90-day deadline, "you're going to put pressure on your agents." As in the earlier instructions for interviewing Bracy, the agents were ordered to complete all interviews and report back within 72 hours, leaving little or no time for independent investigation or study of the case.

The cable, which has been declassified, recounted the Bracy revelations but said they are "very difficult to corroborate" and declared that "this case is being made on the 'details' uncovered by interviews conducted in the field."

The allegations to be corroborated were then outlined, 20 questions were listed to be asked of all interviewees, and agents reminded that prosecution of the case is exclusively assigned to the NIS and the Marines: "Department of Justice is not involved." This made clear to all that NIS' reputation was on the line.

Within a week, the agents had turned up two corroborating witnesses, Cpl. Robert J. Williams in Vienna and Sgt. Vincent Downes in Quantico, Va. Both had served with Bracy in Moscow, both are black as is Bracy, which seemed to give added credence to their story, and both were quoted as saying Bracy had confided to them as he was being expelled from the Soviet capital that he was involved in espionage.

Later both Williams and Downes recanted their statements and accused the NIS of coercing them to make false charges and insisting on describing NIS-generated "speculation" as truth. The Marine Corps brought charges of perjury and false swearing against Williams but later dropped them.

As a result of this, in mid-May the Marine Corps dropped those charges against Lonetree involving his conspiracy with Bracy to bring Soviets into the U.S. Embassy. Lonetree was later tried and convicted on lesser charges of providing written and verbal information to the Soviets about embassy operations and personnel. On June 12, all charges against Bracy were dropped on grounds of insufficient evidence.

Nevertheless, many high government officials continued to put credence in the plot until very recently, believing that smart lawyers and cautious Marines had won the courthouse battles, but that the story still probably was true. Only Lonetree's post-conviction interviews in November convinced many of the holdouts in the administration that the Bracy confession was false.

As a result of the wide-ranging investigation, including some "very sensitive source information," the NIS believes that the KGB is targeting Marines and U.S. Embassy personnel worldwide. Four Marine guards -- Lonetree, Bracy, a former guard from Leningrad and a former guard from an East European country -- are listed by NIS as having admitted to espionage.

Eight other Marines are said to have been "deceptive to espionage questions" on polygraph examinations. But only Lonetree, so far, has been prosecuted. A Navy official described the totality of this as "an enormous national security problem."

An emerging problem for all concerned is what to do now that last spring's KGB-in-the-Embassy charge is fading away, after a national uproar, great embarrassment and the expenditure of at least $30 million to counteract the alleged incursions.

Rep. Daniel A. Mica (D-Fla.), who took the Magic Slate to Moscow last spring, spoke for many when he said in an interview that, considering the severity of the charges, there was no choice but to take prompt countermeasures. "When a fire alarm is pulled, you have to send the fire trucks -- you can't wait for the investigation," Mica said. The lawmaker said the General Accounting Office, the investigating arm of Congress, is studying the NIS investigation at the request of his House Foreign Affairs subcommittee.

The leadership of the NIS has made a recent internal study and found no evidence of "misconduct" or "improper behavior" on the part of NIS agents. No agents have been fired or disciplined, according to the Navy.

At the height of the spy scandal, at least five official inquiries on various aspects of Moscow Embassy security were announced by Reagan or Shultz, but none of them investigated whether a KGB penetration actually took place, where the story came from or why it evaporated. Today nobody has been held accountable and nobody seems anxious to court embarrassment by dwelling on these questions.

Staff researcher Michelle Hall contributed to this report.