The report called for tighter oversight of national police and tough anti-terrorism laws.
Australian Federal Police (AFP) arrested Mohamed Haneef in July 2007 and held him for 11 days without charge after his mobile phone SIM card was found on one of the people accused of the "planned 2007 Glasgow airport attack" in the United Kingdom.
Haneef, who worked for a hospital in northern Queensland state, was later charged with providing support for them, but the charges were eventually dropped and Haneef was allowed to return to his family in India.
"Errors were made from ground level to the highest level," Australia's Attorney-General Robert McClelland told reporters.
"A man was wrongly charged ... a man was detained for longer than was really necessary. These situations are totally unacceptable and should not have occurred."
A judicial inquiry into his arrest, ordered by the new Labor government, found Haneef had no prior knowledge or involvement in the 2007 Glasgow or London attacks and should never have been charged, saying some decisions in the case were "mystifying".
The report said the Australian Secret Intelligence Organisation (ASIO) consistently advised the then conservative government there was no credible evidence against Haneef. The AFP also told the government the same thing, but later changed its position and backed a prosecutor's call to charge Haneef.
The inquiry "cleared" the government of former Prime Minister John Howard of wrongdoing. But it said the government failed to analyse the conflicting opinions held by ASIO and AFP.
"From a whole-of-government perspective ... no serious attempt was ever made to interrogate ASIO's assessment of Dr Haneef or to reconcile it with the approach pursued by the AFP," the report said.
Haneef, now living in the United Arab Emirates, has previously said his family is still coming to terms with what happened in Australia, but he could still return to the country.
McClelland, releasing the report to parliament, said no action would be taken against Australian Federal Police Commissioner Mick Keelty or any other agency head.
He said anti-terror laws would be reformed to "protect the security of Australians while preserving the values and freedoms that are part of the Australian way of life".