Now, after years of corruption allegations and shady financial dealings, the US has threatened economic sanctions over claims that Nauru has issued passports to potential terrorists and provided a financial haven for drug lords and the Russian mafia.

Nauru has been forced to scrap its long-running and highly controversial passports-for-cash scheme and move towards closing some of its 400 offshore banks, after a stern letter of rebuke from US Secretary of State Colin Powell. The 'shell' banks have no physical presence on Nauru and are registered to one government mail box.

'The indiscriminate sale of Nauru's passports to persons having no genuine allegiance or substantial ties to your state contradicts [a commitment to fight terrorism]. I strongly urge Nauru to stop immediately what is in effect the sale of Nauru passports to such individuals. I hope we can count on your support and that you appreciate the serious threat posed by this situation,' Mr Powell wrote.

The warning came as Nauru gears up for an election next month in which its 11,000 citizens will choose a president to replace former leader Bernard Dowiyogo, who died of heart failure in Washington last month. Dowiyogo was in the US to negotiate Nauru's removal from an international money laundering blacklist drawn up by the Organisation for Economic Co-operation and Development.

Nauru, once known as Pleasant Island, is the smallest independent republic in the world and sits just beneath the Equator. Since being colonised by Germany in 1888, it has had a distinctly chequered history.

In World War II it was occupied by the Japanese. After independence in 1968, Nauru earned billions of dollars from the mining and export of the purest natural phosphate in the world. During the 1970s Nauruans enjoyed the world's second-highest per capita income, after Saudi Arabia.

But in a bizarre riches-to-rags story, most of that wealth has been squandered through a series of spectacularly ill-conceived investment projects including, in 1995, the backing of a London musical about the love life of Leonardo Da Vinci. The phosphate is expected to be exhausted by 2008.

Helen Hughes, a senior fellow at the Centre for Independent Studies in Sydney and an expert on Nauru, says: 'The islanders are now flat broke. They have been taken to the cleaners by rogues in Australia, the US and across the Pacific. They fell for every scam, and they are still falling for them. It's like a Gilbert and Sullivan comedy.

'The latest idiotic idea is to build a casino, and for the [Australian] backers to take 50 per cent of the profits. But it will bring in every type of gangster you can imagine. Nauru has one hotel and not one light bulb works.'

Ms Hughes, who advised the government of Nauru on phosphate prices in the 1960s, calculates that if the earnings had been invested wisely, each man, woman and child on Nauru would today be worth A$15 million (about HK$70.6 million). Instead, Nauru is in financial chaos.

Earlier this year Air Nauru's one aircraft was threatened with repossession and the telephone system collapsed, cutting off the island from the rest of the world. Strip-mining has left much of Nauru a bleak moonscape of sun-baked coral.

In a desperate move to secure additional income, Nauru's government accepted a multi-million-dollar aid package from Australia in 2001 in return for detaining unwanted asylum seekers under Canberra's 'Pacific solution'.

The arrangement was supposed to end in June, but the Australian government now wants to negotiate an extension under which the remaining 450 mostly Afghan and Iraqi asylum seekers will remain on Nauru until next year.

The extension will secure Nauru more financial aid but will hardly enhance its battered international image.

'What Nauru needs is a sound financial adviser who will tell them to pay their debts, see what they have left, and then live within their means. They certainly don't deserve any more aid. They have been exploited by every nasty crook in the world, but they are grown-ups, they had a choice,' Ms Hughes says.