Lord Peter Goldsmith, the British attorney-general, said the decision had been made "in the wider public interest", which had to be balanced against the rule of law.
He told the House of Lords that Tony Blair, the British prime minister, had agreed that the continuation of the investigation would cause "serious damage" to British-Saudi relations.
He said Blair and Des Browne, the British defence secretary, "have expressed the clear view that continuation of the investigation would cause serious damage to UK/Saudi security, intelligence and diplomatic co-operation".
He said this in turn "is likely to have seriously negative consequences for the UK public interest in terms of both national security and our highest priority foreign policy objectives in the Middle East".
The SFO said in a statement: "No weight has been given to commercial interests or to the national economic interest."