The government acted to head off a growing backbench rebellion against its NHS legislation last night by severely curbing the independence and powers of foundation hospitals.

Although they will escape direct ministerial control, there will be strict limits on the number of private patients they can treat, the pay rates they can offer, and the extent to which they can depart from the values and traditions of the NHS.

Alan Milburn, the health secretary, was so keen to show that his proposals would not lead to a two-tier NHS that he may have taken away many of the reasons why 32 of England's best hospital trusts have been attracted to apply for a place in the first wave of conversion to foundation status in April 2004. The health and social care bill published yesterday says foundation hospital trusts will be set up as "public benefit corporations", governed by boards that will for the most part be elected by local people and staff.

Earlier drafts of the bill referred to the trusts as "companies", but that word does not occur in the 135 pages of text.

Mr Milburn said this was "a new model of public ownership, firmly rooted in the cooperative and mutual tradition". Foundation trusts would be owned and controlled by local communities, rather than central government or shareholders. "They will be not-for-profit organisations, wholly part of the NHS, subject to NHS standards and inspections, but no longer directed from Whitehall."

Their affairs would be supervised by a regulator who will be obliged to intervene if they do anything detrimental to the wider NHS.

Specifically, the bill imposes a statutory duty on foundation trusts not to increase above the current level the proportion of income derived from private patients. John Hutton, the health minister, said he was ex amining how applicants for foundation status might be encouraged to give up private work altogether. The restriction on private work was inserted to allay the fears of the 124 Labour backbenchers who have signed a motion criticising the proposals. Seven had added their names in the preceding 24 hours.

Many feared that foundation hospitals would be under financial pressure to take more private patients to pay back the extra money they would be allowed to borrow. They are also concerned that foundation hospitals might be able to poach the best staff by offering higher pay.

Mr Hutton said the regulator would stop unfair poaching and limit local pay flexibility to the amount agreed with the unions in the recently negotiated agenda for change. A foundation trust would be able to retain income from selling surplus assets and borrow without government permission as long as it did not exceed prudent limits.

The loans would not be underwritten by the government. In the event of insolvency, the regulator would have the power to sack the board and pass the assets to another NHS body or the secretary of state.

Mr Hutton said the banks could be assured that the regulator would not let foundation trusts over-extend themselves. In the event of a default, income would continue to flow from treating NHS patients.

Every NHS trust would be able to gain foundation status "over the next four to five years," he said. But he denied that this implied a devaluation of the government's earlier commitment to maintain tight control of weak hospitals. Within five years, all NHS hospitals would have improved. Under the plan to make foundation trusts accountable to their communities, people in the catchment area would pay £1 to become members of the corporation, entitled to vote by post to elect more than half the board of governors.

Gill Morgan, chief executive of the NHS Confederation, representing health service managers and trusts, said: "We believe foundations could be an important first step towards a more decentralised NHS."

But Frank Dobson, a former Labour health secretary and leading critic of the plans, said most backbenchers would not be impressed by the concessions. "The regulator will not be able to break the law on employment or human rights.

"Foundation hospitals will be better funded. Nobody can stop staff from neighbouring hospitals applying for jobs there. Ministers say all hospitals will be foundation in four or five years. That's a long time to be at the back of a queue. As time goes by, poaching will increase in intensity, because there will be more poachers and fewer people to poach."

Main points

· The bill enables a new type of foundation hospital in England, providing free care to NHS patients but without Whitehall's direct control.

· Foundation hospitals will be not-for-profit "public interest corporations". Governors will be elected by local people, but decisions will be closely supervised by an independent regulator.

· They will not be allowed to reduce their commitment to the NHS by taking on more private patients.

· The bill will set up tougher inspectorates for all hospitals and social services.

· The bill enables the NHS to recover from insurers the cost of treating people who receive injury compensation.

· The welfare food scheme will be reformed to give pregnant women, mothers and young children better access to a healthy diet.

· Primary care trusts will be responsible for NHS dentistry.