Washington wants the 38 year old German national, also known as Kim Schmitz, to be sent to the United States to face charges of internet piracy and breaking copyright laws.
Thursday's report by the Inspector-General of Intelligence, the official watchdog for New Zealand spy agencies, found the Government Communications and Security Bureau (GCSB) had spied on Dotcom, despite a law prohibiting it from spying on New Zealand citizens and residents.
The flamboyant Dotcom attained New Zealand permanent residency status in 2010.
"It is the GCSB's responsibility to act within the law, and it is hugely disappointing that in this case its actions fell outside the law," Prime Minister John Key said in a statement, adding the blunder was the result of "basic errors".
Key apologised to Dotcom and all New Zealanders, saying they were entitled to be protected by the law and that it had failed them.
New Zealand police asked the GCSB to keep track of Dotcom and his colleagues before a raid in late January on his rented country estate near Auckland, which saw computers and hard drives, works of art, and cars confiscated.
The illegal surveillance may deal another blow to the U.S. extradition case after a New Zealand court ruled in June that search warrants used in the raid on Dotcom's home were illegal.
The raid followed a request by the Federal Bureau of Investigation (FBI) for the arrest of Dotcom for leading a group that netted $175 million since 2005 by allegedly copying and distributing music, films and other copyrighted content without authorisation.
Dotcom maintains that the Megaupload site was no more than an online storage facility, and has accused Hollywood of lobbying the U.S. government to prosecute him.
U.S. authorities are currently appealing a New Zealand court decision that Dotcom should be allowed to see the evidence on which the extradition hearing will be based.
The extradition hearing has been delayed until March 2013.
Copyright Thomson Reuters 2012
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