Information has been passed to Newsnight by a former officer, who is familiar with the original investigation and its closure.
The order to scrap the probe, made after Smith and others had been arrested, came from a senior officer whom the undercover team had never met before, according to the source.
Officers were then ordered to hand over all their evidence - including notebooks and video footage - and were warned to keep quiet about the investigation or face prosecution under the Official Secrets Act, it is claimed.
That evidence included pictures and video taken from inside the flat, as a hidden camera had been installed with the help of a caretaker.
Smith is said to have been one of those caught on camera, another being a senior member of Britain's intelligence agencies.
According to an account given to the BBC, Smith was later seized at a property in Streatham, south London, where he had reportedly been taking part in a sex party with teenage boys.
But it was claimed he was released that night and a duty sergeant who wanted to keep him in custody was reprimanded.
The BBC has been told that as well as Smith and the member of the intelligence agencies, the undercover team also had evidence on two senior police officers.
The squad believed that boys from care homes were being provided "to order" for sex parties, but the inquiry was abruptly shelved, the BBC has been told.
They were read passages from the Official Secrets Act to deter them from speaking out, according to one account.
There was a row at the police building but the inquiry was closed and officers were assured Smith "would not be playing a role in public life any more". In fact, he continued as MP for Rochdale until 1992.
Newsnight's source spoke to the programme through an intermediary and is fearful of repercussions because of the scale of the alleged cover-up.
"He was protected because he knew of other paedophiles in the networks in which he operated and had he been prosecuted, then I think those other people would have been named by Smith and that's why they ensured that he was never put before the courts."
"Certainly the timing and the type of allegations that are made are ones that the Met would take very, very seriously."
He described the claimed as "very credible and very frightening".
"If you take all of the information that appears to be out there together it does look like collusion with police officers and other agencies to prevent what is a straightforward criminal case," he added.
[link to m.bbc.co.uk
a few snippets from the above link