The consignment of 440 ground squirrels did not have the necessary health and import papers for their trip from Beijing, China, to Athens, Greece.
Facing a growing storm of protest, a spokesman for the airline said: "Though on formal grounds the action taken was correct, KLM admits to having made a grave mistake on ethical grounds."
Despite the company's insistence that it "fully endorsed" criticism of its action, animal rights groups have expressed outrage and accused airlines of further abuses.
The animals were destroyed on Monday under orders from the Dutch Ministry of Nature Management in a machine normally used to slaughter poultry.
'On the run'
The employee responsible for the action has since been suspended, even though KLM said he was right to obey the order from the ministry.
The company said that he had "made an incorrect assessment of the solution".
About 20 squirrels are reported to have escaped and are now on the run.
The Netherlands' Organization for Pets also accused airlines of destroying an earlier batch of squirrels, in addition to water turtles and a selection of rare birds during the last few months.
'It makes me nauseous'
Spokesman Mattheus Beyenberg said: "We are going to do everything possible to try to have this type of machine banned."
KLM has already ceased shipments of live animals and is reconsidering its policy with respect to shipping all varieties of exotic wildlife.
But KLM spokesman Joessef Eddiei said the shredder was "the most humane way to destroy animals".
The De Meern Foundation for Squirrel Refuge - the only specialist squirrel rescue centre in the Netherlands - said it had not been approached before the consignment was slaughtered.
Founder Mieke Holtslag said: "Just the fact that they killed them makes me nauseous, let alone how they did it".
The Dutch Ministry of Agriculture has launched an inquiry into the killings with a view to taking legal action if necessary.
Country profiles
Stormont squirrels bridge the divide
(01 Apr 99 | Sci/Tech)
Squirrels 'cannot live by nuts alone'
(28 Dec 98 | UK)
Squirrels red and dead
(16 Apr 99 | UK)
Shoot the little grey menace
(23 Jun 98 | UK Politics)
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