Prime Minister John Key has left the door open for the Serco to rebid for the Mt Eden prison contract in the future.
The private prison operator's $300 million contract at Mt Eden is ending in 2017 under an early-out clause, four years shy of its 10 year term.
The decision not to renew its contract follows an investigation into drug use and fight clubs at the prison.
Corrections has been managing Mr Eden since July when it invoked a step-in clause in its contract.
Serco has been dropped from its contract to run Mt Eden prison. Photo: RNZ / Diego Opatowski
But Mr Key rejected the suggestion that the government's privatisation programme had failed.
"In a funny kind of way it showed it worked because we got a contract and the contract allowed us to do something that you could never actually do with a government department and that is to say 'we're not going to renew that contract, certainly not under the conditions they were negotiated'."
Mr Key said Corrections was likely to be heavily involved in the running of Mt Eden prison until 2017.
"There's a range of options available after that, including potentially Serco wanting to re-pitch or re-tender, another private provider, or of course the government wanting to take it over."
Any operator who bids for the Mt Eden contract in 2017 would have to demonstrate to the government, and the public, that they were capable of running a prison, he said.
Serco keeps its contract to run Wiri prison in South Auckland.
Labour Corrections spokesperson Kelvin Davis has scoffed at the idea Serco could allowed to have another go at running the prison.
Mr Davis told Morning Report the company had failed abysmally, and if the Government gave Serco another crack at it, in a few years time they'll would end up reliving the same nightmare all over again.
Meanwhile, a prison officers union said the government was taking the easy way out by not terminating Serco's Mt Eden contract immediately.
Corrections Association spokesman Bevan Hanlon said Serco had already taken Corrections to court over issues at Mt Eden.
He said allowing the company's contract to run another 15 months was the easy option for the government, as it was avoiding any further legal costs.
New Zealand First leader Winston Peters said Serco's record was "appalling" and it should not be allowed to continue to run Wiri or any prison in the county for that matter.
"The government shouldn't have been going into this stupid experiment in the first place. They knew the Serco record world wide.
"So why was [incoming Corrections Minister] Judith Collins allowed to launch this silly, myopically right-wing idea which was bound to fail? But now she's being rewarded for it. She's back."
Green Party spokesman David Clendon said Serco's contract should be terminated immediately instead of running its course.
"The opposition parties, inmates, families of inmates and prison staff have been saying for six months that Mt Eden is an unsafe prison.
"The government has now got egg on its face having to admit belatedly that they got it very wrong."
United Future leader Peter Dunne said Serco's contract with Mt Eden prison was a "boil that needed to be lanced".
He did not expect to see Serco re-win the contract due to its past performance.
An investigation by Corrections chief inspector into the allegations of assault and fight clubs has been completed, but its release has been delayed because of a High Court challenge by Serco.