Millions of policy holders could be affected by the FSA's crackdown
The Financial Services Authority (FSA) has told banks and other lenders to compensate customers who may have been mis-sold payment protection insurance.
The order has been given initially to firms responsible for selling more than 40% of "single-premium" PPI policies when giving unsecured personal loans.
The FSA will now target other firms that have mis-sold PPI when offering secured loans or credit cards.
All firms have also been told to reopen 185,000 rejected complaints about PPI.
PPI is supposed to repay people's loans if they fall ill or become unemployed.
But after years of complaints from consumer groups that the cover was often useless, and little more a than a "protection racket" designed to generate inflated profits for lenders, the authorities have been taking action.
The FSA's tougher stance has been provoked by evidence that firms have been fobbing off justified complaints, thus forcing disgruntled customers to pursue a complaint to the Financial Ombudsman Service (FOS).
The regulator revealed that, overall, firms had been rejecting 60% of the PPI complaints they had received.
Of these, 16% had then gone to the FOS where 80% were then upheld in the customer's favour.
The FSA said it was now giving the financial services industry a "last chance".
"It is unacceptable that despite previous warnings about poor sales practices, backed by 22 enforcement cases and significant fines, the PPI sector still needs the FSA to intervene on this," said Jon Pain, the FSA's managing director of retail markets.
"And the outcome of a complaint about a PPI sale should not depend on whether or not the complainant persists past the firm on to the Financial Ombudsman Service.
"All firms operating in this sector should take note and where necessary, get their house in order," he added.
The firms who have so far been identified as mis-selling "single premium" PPI have been told to go through their past sales and compensate customers where appropriate.
The FSA said that about 10 firms had agreed to this, although it would not name them.
They will look at their past sales going back to 1 July 2007, but if many problems are found, they will have to reopen their files going back to January 2005.
Customers will be sent a letter telling them there is a potential problem, advising them they may receive compensation and that they should contact the firm that sold them the insurance.
The FSA has focused so far on "single premium" PPI because it has been the most widely sold version of the insurance.
The other firms in this market are still being scrutinised by the FSA.
As well as demanding that all PPI sellers reopen complaints that have previously been rejected, the regulator is also insisting that they are dealt with properly according to new guidelines.
The consumers association Which? demanded action against other financial firms.
"PPI isn't the only area where FSA action is needed - the Ombudsman's complaint statistics show too many firms selling a range of different products, which have had a higher-than-average number of complaints upheld against them," said Louise Hanson, head of campaigns at Which?
"Unless big fines are levied, businesses will keep on unfairly dismissing complaints, safe in the knowledge that if they get caught, all they'll have to do is go back and look at them again."
The sale of all PPI will be severely restricted from October 2010 as a result of a recommendation from the Competition Commission, which said lenders should not sell PPI at the point at which they grant a loan, or for seven days afterwards.
Earlier this year the FSA took action against the "single premium" version of the insurance and told firms to stop selling it immediately.
In this type of policy, the cost is added as a lump sum to the loan, which means borrowers end up paying interest on the insurance premium as well as the loan itself.
The FSA's move was welcomed by its own consumer panel.
"The selling of PPI has a notorious history," said Adam Phillips of the Financial Services Consumer Panel.
"We welcome the FSA's proposal today to force firms to re-visit all rejected complaints about sales of PPI and re-examine them against new FSA guidance.
"However, this action has taken a long time, and the FSA still needs to tackle PPI sold with credit cards, secured loans and mortgages where people may not have complained," he added.