The 57-year-old man, known as David S, is suspected of selling documents to a representative of a Russian intelligence service.
A British embassy worker arrested in Germany on suspicion of spying for Russia was being monitored by MI5, Sky News understands.
The British national, named as David S, was detained in Potsdam over allegations that he had been working “for a foreign secret service”, the German public prosecutor said.
A statement from the German prosecutor said: “Until his arrest, David S worked as a local employee at the British Embassy in Berlin.
“On at least one occasion he forwarded documents obtained in the course of his professional activities to a representative of a Russian intelligence service.
“In return for providing information, the accused received cash in a previously unknown amount.”
Sky’s Middle East correspondent Alistair Bunkall understands the man’s alleged activities “had been known about for some time” and he was being monitored by British security services.
The arrest is the result of a joint investigation by German and British authorities and was not a “snap arrest”, according to Bunkall.
Investigators have searched his home and office, the prosecutor’s statement said.
Germany’s foreign ministry said it was taking the case “very seriously” and that spying on allied states on German soil is unacceptable.
The Metropolitan Police said the 57-year-old had been arrested “on suspicion of committing offences relating to being engaged in ‘Intelligence Agent activity’ (under German law)”.
The force’s counter terrorism command is responsible for investigating alleged breaches of the Official Secrets Act.
David S is expected to appear at the Federal Court of Justice in Germany later.
A UK government spokesperson said: “An individual who was contracted to work for the government was arrested yesterday by the German authorities.
“It would not be appropriate to comment further as there is an ongoing police investigation.”
Labour said the arrest raised “questions” over who is in charge of security issues in government.
The security minister post has been vacant for more than a month after James Brokenshire stepped down to focus on his cancer recovery.
Shadow security minister Conor McGinn said: “Britain’s national security is under threat 24 hours a day, seven days a week, but the UK has not had a security minister in position for over a month.
“Following today’s events, it raises questions about who in Government is overseeing the most serious task of keeping the British public safe and secure.”
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