US Deputy Defence Secretary Paul Wolfowitz made the announcement late on Tuesday when asked by members of Congress about the controversial scheme.
"It sounds like maybe they got too imaginative in this case," said Wolfowitz.
Called "Futures Market Applied to Prediction" or FutureMap, the programme was created by the same Pentagon office that drew fire last year for proposing surveillance of electronic transactions on a massive scale to detect traces of "terrorist" activities.
The Pentagon plans called for setting up an Internet-based market where as many as 10,000 participants would in effect bet on the timing and probability of possible major events such as the assassination of Palestinian President Yassir Arafat and Jordan's King Abd Allah II.
The political scenarios were being developed by the Defence Advanced Research Project Agency (DARPA).
"It sounds like maybe they got too imaginative in this case."
--US Deputy Defence Secretary Paul Wolfowitz
The scheme sought to use market forces as a tool to predict future political events and avoid strategic surprises.
Lawmakers and media commentators have criticised methods of gaining intelligence since the attacks of 11 September 2001 in New York and the Pentagon.
"Futures markets have proven themselves to be good at predicting such things as elections results; they are often better than expert opinions," the agency said in a statement Monday.
But US Senators Ron Wyden of Oregon and Byron Dorgan of North Dakota, both Democrats, said they wanted the programme stopped before it starts registering traders on 1 August.
"The idea of a federal betting parlour on atrocities and terrorism is ridiculous and grotesque," Wyden, who sits on the Senate Intelligence Committee, told reporters Monday.
Wyden has been prominent among congressional critics of another DARPA program, Terrorism Information Awareness (TIA), a computer surveillance initiative that raised concerns about invasions of individuals' privacy.
He said the new "Policy Analysis Market" trading scheme is overseen by TIA chief retired admiral John Poindexter, a central figure in the Iran-Contra scandal, in which US officials illegally funded Nicaraguan rebels with proceeds from also-illegal arms sales to Iran in the mid-1980s.
Dorgan described the Internet scheme as "unbelievably stupid."
"How would you feel if you were the King of Jordan and you learned the US defence department was taking bets on your being overthrown within a year?" he added, noting that Jordan has long been a US ally.
How it works
"How would you feel if you were the King of Jordan and you learned the US defence department was taking bets on your being overthrown within a year?"
--US Senator Byron Dorgan
DARPA's contracts would focus on "the economic, civil, and military futures of Egypt, Jordan, Iran, Iraq, Israel, Saudi Arabia, Syria, and Turkey and the impact of US involvement with each," according to the agency's "Policy Analysis Market" Web site.
The system draws on methods that Middle East analysts use with petroleum futures contract prices to predict events in the region.
Traders, who would have to deposit money with the market before being able to make any trades, would buy contracts for an event they considered likely and attempt to sell contracts if they thought it unlikely.
The more buyers there were for a contract – for example, Arafat's assassination in the first quarter of 2004 – the more likely it would be considered and the higher the price. If the event came to pass, buyers would cash in and sellers would lose out.
Starting on Friday, up to 1,000 individuals will be allowed to register and will begin live trading on 1 October, DARPA's Web site said. Their numbers would be increased to at least 10,000 worldwide by 1 January.
The Internet market site would be run by private technology firm Net Exchange with data and analysis provided by the Economist Intelligence Unit, the business information arm of the publisher of The Economist magazine.
Government agencies will be barred from taking part and from access to traders' identities or funds, DARPA said.