BAE Systems is in talks with the government of Saudi Arabia over an extension to the controversial 15 billion pounds sterling Al Yamamah contract, which was the subject of slush-fund allegations last week.

Defence-industry sources say that discussions between BAE, the Ministry of Defence and the Saudis are "progressing well".

The new agreement - there have been two previous Al Yamamah deals - would centre on BAE making substantial improvements to the oil-rich kingdom's fleet of British-built Tornado fighter-bombers. The deal would also extend BAE's service contracts to support Saudi Arabia's armed forces. BAE has 5 500 workers in the country, 2 500 of whom are expatriates.

Winning a new contract in Saudi Arabia could be crucial to BAE's future. The company's long-held ambition to forge a transatlantic partnership with a big American defence company has been hamstrung by its flagging share price. A new Al Yamamah arrangement would send BAE's shares soaring.

The Saudi contracts were a leading source of BAE's income during the late 1980s and through the 1990s.

According to defence analysts, the Al Yamamah work gave BAE margins as high 25% on sales - a level the company has achieved in few other areas of its activity.

But Al Yamamah has always been controversial. Last week allegations surfaced that the company had maintained a slush fund to bribe Saudi officials, with company money allegedly used to pay for yachts, a house and prostitutes. There were also claims that BAE had been defrauded by British defence executives who had taken the slush-fund money for personal use.

On Thursday, Mike Turner, BAE chief executive, denied the allegations, saying they were "old hat". The company issued a statement saying that it "vigorously rejects allegations of wrongdoing ... BAE Systems operates rigorously within the laws of both the UK and the countries in which it operates".

Turner also said that the company would not sue The Guardian, which carried the allegations, because "if you take action you simply prolong the allegations".

Defence-industry executives said last night that the allegations were an embarrassment during the negotiations with the Saudis and the Ministry of Defence, and that the company would want them to die down as quickly as possible.

Saudi Arabia bought some 120 Tornados from BAE under the first two Al Yamamah contracts, which together were worth Pounds 15billion. It is understood that the Royal Saudi Air Force is considering retiring some of the aircraft in order to pay for an upgrade to the rest of the fleet. The work under consideration would contain some elements of the recent Pounds 1billion GR4 update to 142 of the Royal Air Force's Tornado fleet.

The project is known within BAE as the "Saudi sustainment programme". The GR4 upgrade gave Britain's Tornados sophisticated new infra-red sensors, high-tech avionics and laser-designation equipment - allowing them to launch the latest smart bombs and cruise missiles. The Saudi requirement is likely to be more basic.

One defence-industry expert said that BAE could be asked to upgrade the Saudi Tornados' avionics, and to provide the capability to carry the Brimstone missile, which is expected to go into service with British forces next year.

With acknowledgements to Dominic O'Connell and Sunday Times (London).