The Metropolitan police have launched an investigation into the use of intermediaries to launder donations to the Labour party.
The Electoral Commission has asked Scotland Yard to investigate the circumstances surrounding the donations originating from property developer David Abrahams.
Mr Abrahams has donated more than £650,000 to the Labour party over the past four years. In an attempt to "avoid publicity" he funnelled the money through four associates; Janet Kidd, Janet Dunn, John McCarthy and Ray Ruddick.
Under the Political Parties, Elections and Referendum Act 2000, any donor using a conduit must still be registered and reported to the Electoral Commission.
Labour's general secretary Peter Watt resigned on Monday, admitting he had broken the law but blaming ignorance rather than wilful defiance.
Speaking to reporters on Tuesday, Gordon Brown said the donations had been "unlawful" and would be repaid.
A criminal investigation has appeared inevitable since senior Labour officials seemingly admitted the law had been broken.
In prime minister's questions, David Cameron demanded to know why Mr Brown had not reported the matter to the police himself if he believed electoral laws had been breached.
The prime minister responded that it was up to the Electoral Commission to investigate and judge whether the matter warranted a criminal inquiry.
Scotland Yard will now seek to establish who knew the money was being donated through proxies and who broke the law.
The Conservatives have welcomed the police investigation, which sees Labour's finances investigated by the Met for the second time in as many years.
Shadow Cabinet minister Chris Grayling said: "The prime minister himself has said the law has been broken, and it is vital that all the circumstances are now investigation fully by the appropriate authorities."
The Liberal Democrats have been gunning for a criminal investigation and are critical of Labour's reliance on wealthy donors.
Leadership candidate Chris Huhne said: "This is welcome because only the police have the power to investigate the true identities lying behind these secret donations.
"Until we know who has donated this money we will not be sure that British politics is both clean, and seen to be clean."