The Home Office will not receive any extra cash to honour a government pledge of 8,000 new prison places.
The department's budget has been frozen by Chancellor Gordon Brown for the next five years, the News of the World reported.
The Treasury confirmed that funding for the project will have to come from the Home Office's existing budget.
The News of the World said the project will cost £1.5bn for construction plus £35m a year to run and has been approved by the Prime Minister.
It reported that the Home Office will have a fixed budget of £2.1bn a year for the next five years, with the only rise to account for inflation.
But both the Treasury and the Home Office said the planned prison expansion will still go ahead.
A Home Office spokeswoman said: "We are committed to building an extra 8,000 prison places as the Home Secretary stated in July. The way we will fund them is still being finalised but it will be a mixture of public and private finance."
The spokeswoman added that half of the places will come from expansion of existing prisons and half will be on new sites.
A Treasury spokesman said: "In the summer, agreement was reached to increase prison capacity significantly over coming years, with an additional 8,000 places to be added to the existing 80,000 prison places. This builds further on the increase of 19,700 prison places seen since 1997."
Shadow Home Secretary David Davis said: "It is not just the failure of the Home Office that is putting the public at risk, Gordon Brown must bear some responsibility."
