Downing Street political adviser Ruth Turner has become the fourth person to be arrested by police investigating the cash-for-honours allegations.
Ruth Turner is a key Downing Street official
Ms Turner was arrested at 0630 GMT but later released on police bail after being quizzed for several hours.
She was questioned over honours allegations and suspicion of perverting the course of justice. She has issued a statement denying any wrongdoing.
Tony Blair gave Ms Turner, one of his closest aides, his full backing.
"Ruth is a person of the highest integrity for whom I have great regard and I continue to have complete confidence in her," said the prime minister.
In a statement released by 10 Downing Street, Ms Turner said: "I absolutely refute any allegations of wrongdoing of any nature whatsoever."
The Metropolitan Police team investigating claims people gave political donations in exchange for peerages have so far spoken to about 90 including Mr Blair. All deny wrongdoing.
Ms Turner, who as director of government relations is a vital link between Downing Street and the Labour Party, was first questioned by police in September.
A Downing Street source told the BBC officials had been "taken aback" by her arrest, which took place at 0630GMT.
Angus MacNeill, the SNP MP who sparked the cash for honours probe, said: "I think it just underlines the seriousness of the situation facing Downing Street, something they haven't fully faced up to."
He said "water is now lapping around Tony Blair's neck".
Mr Blair and former Tory leader Michael Howard are among those who have been questioned by police over the issue.
But until Friday only three people had been arrested - Lord Levy, the Labour Party's chief fundraiser, Labour donor Sir Christopher Evans and head teacher Des Smith, who was involved in the government's City Academy programme.
No one has been charged.
The inquiry began after it emerged that a number of large secret loans had been made to the Labour Party before the 2005 general election, and that some of those lenders had subsequently been nominated for peerages.
The investigation has since widened to cover the other main parties.
Scotland Yard had been expected to hand over a file on the case in January to the Crown Prosecution Service, which will decide whether any charges should be brought.
But a police spokesman said on Friday: "As a result of this new development additional investigation will be required before a final file can be submitted to the CPS."
Attorney general role
Labour peer Lord David Puttnam, who is a friend of Ms Turner's, told BBC Radio Five Live: "She's one of those half dozen, dozen people who I would stake my life on. She's a woman of total, total probity.
"There's no question in my mind that for whatever reason the police have done this they have, to use the phrase, fingered the wrong person."
Lib Dem Treasury spokesman Vincent Cable told the BBC the allegations were doing "a lot of damage" to the credibility of the government and showed the need for rapid agreement on party funding and reform of the House of Lords.
"The government in general and the prime minister in particular just seem now hopelessly mired in sleaze and they just cannot escape from it," he said.
Meanwhile a letter has been published from Attorney General Lord Goldsmith, a close ally of Mr Blair and the government's chief legal adviser, dismissing suggestions by the Lord Chancellor that he would stand aside from a decision on any potential prosecutions.
In a letter released by the Constitutional Affairs Committee he wrote: "No other minister, however distinguished or senior, has the ability to bind the attorney general in how he exercises his role."
Lord Goldsmith has said his statutory responsibility to advise on sensitive cases meant it would not be right for him to stand aside, despite criticism there could be a conflict of interest.