Theresa May scrapped the Chancellor’s headline policy - a hike in National Insurance contributions for the self-employed - after a backbench rebellion over what amounted to a broken manifesto pledge.
Tory MPs said the fiasco had been “hugely damaging” to Mr Hammond’s authority, with one saying he was now “on probation”.
With Mr Hammond now looking increasingly isolated from Number 10, a Conservative source said the Prime Minister had “dug her stiletto in and told him, ‘We are reversing this – I don’t care how bad it is for you’.”
Mr Hammond admitted in a letter to Conservative MPs that the NI rise had broken the “spirit” of the manifesto.
He said: “In light of what has emerged as a clear view among colleagues and a significant section of the public, I have decided not to proceed with the Class 4 NIC measures set out in the Budget.”
John McDonnell, the shadow chancellor, said the Government had descended into “chaos”, while Angus Robertson of the SNP described the decision as “a screeching, embarrassing U-turn”.
Small businesses and sole traders reacted with glee to the policy reversal, which came just a week after it was announced in the Budget.
Rebel Conservative MPs reacted with relief. Stephen McPartland, one of the leaders of the mutiny, said: “I think it shows he is a strong Chancellor as he has listened to us and had the guts to accept he made a mistake.”
But it leaves a £2 billion hole in Mr Hammond’s balance sheet, which must now be addressed with new tax measures in the autumn Budget.
There was also fury among Tory MPs who had spent the last week defending the controversial policy.
Ed Vaizey took to Twitter to say: "Blimey. I've been vigorously defending it."
Blimey. I've been vigorously defending it... https://t.co/WQKXZYWgaK— Ed Vaizey (@edvaizey) March 15, 2017
It also raised the chances of future rebellions, with one Tory MP saying: “The big thing it means is that if anything comes up that I don't like then I'll just go for it.”
Although the decision to drop the NICs rise had been widely anticipated, the speed of the about-turn took MPs completely by surprise.
Government ministers had no idea it was coming until the letter from Mr Hammond was emailed to them at 11.38am. One minister, Rory Stewart, found out live on TV, having spent several minutes defending the policy, only to be told it had been scrapped.
Mrs May told Mr Hammond the policy was being scrapped at an 8am meeting in Downing Street.
One senior Conservative MP said Mr Hammond was now on a “sort of probation - she has picked up his mess and disposed of it. She won’t take kindly if it’s repeated that’s for sure.
“She comes out of it really strong – you know who is wearing the trousers in that relationship.”
Another source said that Mr Hammond has been left increasingly isolated, with his all-important reputation as a “safe pair of hands” in shreds.
“He is not out of the woods yet,” stressed one Tory MP.
His relationship with Mrs May was badly damaged over the weekend when sources close to Mr Hammond briefed against Number 10, suggesting Mrs May’s staff were “economically illiterate”.
“He went back on this with gritted teeth,” said one source.
“He is clearly not in that inner circle. There has been huge, huge damage done by the Treasury when it briefed against Downing Street. You don't brief against the boss.”
Mr Hammond’s credibility was further weakened when he appeared to suggest in the Commons on Wednesday that he had only realised the NICs policy amounted to a serious manifesto breach when it was pointed out by the BBC’s Laura Kuenssberg.
He later added that he was aware of the manifesto pledge, but believed it had been “discharged” by legislation that prevented a rise in Class 1 NICs, paid by employees.
Aides said he was making “the factual comment” that the BBC’s political editor was “the first to publicly raise the issue”.
Mrs May was forced to act after accepting that the credibility of her next general election manifesto was at stake if she did not.
Mr Hammond said in his letter that “in light of the debate over the last few days it is clear that compliance with the ‘legislative’ test of the manifesto commitment is not adequate.
“It is very important both to me and to the Prime Minister that we are compliant not just with the letter, but also the spirit, of the commitments that were made.”
Mr Hammond is expected to meet backbench MPs in the coming days to try to restore his authority in the party. Cabinet ministers were lukewarm in their defence of Mr Hammond.
One told The Telegraph: "He did what he had to do."
A second member of the Cabinet added: "Philip took a sensible decision." For hard Brexiteers, the Budget shambles had already represented an opportunity to oust Mr Hammond, because they do not trust him to push for a hard Brexit, with some suggesting he is “not a Tory”.
Tory former chancellor Lord Lamont said the tax hike had been a "bad error of judgment".