Imam Salahuddin Muhammad could hardly miss Shahed Hussain when he first appeared three years ago at his mosque in the dilapidated town of Newburgh, just 60 miles up the Hudson River from New York.

Newburgh Four member James Cromitie is led away by police. At trial, the judge said Cromitie was a man 'whose buffoonery is positively Shakespearean in its scope'. (Photograph: Robert Mecea/AP) Hussain was flash, drove expensive cars and treated people to gifts of cash and food. He also had radical opinions that stood out in a mosque that welcomed Shia and Sunni followers and had good relations with local Jewish and Christian communities.

"This guy said women should not be heard, not be seen. I thought that was strange," Muhammad told the Guardian as he sat in his office inside Newburgh's mosque." Muhammad, who is a black American convert, had no idea how strange things would get.

Hussain would make Newburgh's Muslim community famous when earlier this year four other black Newburgh Muslims were jailed for 25 years for a 2009 plot to fire a Stinger missile at US military planes. They also planted car bombs, packed with lethal ball bearings, outside Jewish targets in the wealthy New York suburb of Riverdale.

Prosecutors painted them as America-hating terrorists bent on slaughter. All four followed the instructions of Hussain, who meticulously organized the scheme: from getting the missile and bombs, to reconnaissance missions, to teaching the tenets of radical Islam.

The "Newburgh Four" now languish in jail. Hussain does not. For Hussain was a fake. In fact, Hussain worked for the FBI as an informant trawling mosques in hope of picking up radicals.

Yet far from being active militants, the four men he attracted were impoverished individuals struggling with Newburgh's grim epidemic of crack, drug crime and poverty. One had mental issues so severe his apartment contained bottles of his own urine. He also believed Florida was a foreign country.

Hussain offered the men huge financial inducements to carry out the plot – including $250,000 to one man – and free holidays and expensive cars.

As defence lawyers poured through the evidence, the Newburgh Four came to represent the most extreme form of a controversial FBI policy to use invented terrorist plots to lure targets. "There has been no case as egregious as this. It is unique in the incentive the government provided. A quarter million dollars?" said Professor Karen Greenberg, a terrorism expert at Fordham University.

Lawyers for the Newburgh Four have appealed. Their case will now be heard early next year. It is sure to prompt a re-examination of the way Hussain and the FBI invented a terrorist plot involving impoverished black Muslims in an economically deprived city.

The case will question the new ethos of the FBI, which, since the terror attacks of 9/11, has focused on pre-emptive prosecution. It also raises serious questions as to how the FBI has treated Muslim communities in America, who it says are a key ally in fighting terrorism, and yet are subjected to such tactics.

If the appeal fails, some believe the Newburgh Four case could end up at the Supreme Court. That won't be much comfort to Newburgh's Muslim community. "It felt terrible being targeted," said Muhammad. On his office walls hung several awards praising his work on inter-faith projects and promotion of peace. "We worked so hard to establish this place. Then our beautiful mosque is in newspapers all over the world," he said.

There is little doubt Newburgh has serious social problems. The wide expanse of Broadway sweeps to the Hudson as grandly as it did in the city's 19th-century heyday, but many shops are boarded up. Side streets are full of houses falling apart, boarded up, or burnt out. Even at 9am drug dealers openly ply their trade.

It is this poverty-drenched environment in which Hussain met James Cromitie, a loudmouth Walmart worker who claimed to deal drugs and stolen goods. Exactly why Hussain picked Newburgh is not clear. He had already acted as an informant in another controversial "entrapment" case in Albany, New York, where a local pizza owner and an imam were convicted for terrorist money laundering.

Now Hussain's brief was to fish for new suspects. He claimed to find one in Cromitie, who was prone to anti-Semitic rants. Hussain coaxed Cromitie along, eventually developing the plot to attack Riverdale and a US airbase on behalf of a Pakistani terrorist group. It was Cromitie who then recruited the other three men – David Williams, Onta Williams and Laguerre Payen – to fulfill Hussain's desire for lookouts.

From then, the FBI prosecution seemed straightforward. After all, even though the plot was fake, the men seemed to think they were carrying out an Islamic terror attack. Prosecutors believed they were a real threat. But it is not that simple.

None of the four men fit the usual profile of a terrorist-in-waiting, let alone an active militant. But they did fit the profile of desperate men who would do anything for money – and Hussain promised massive earthly awards.

For Cromitie, he proffered $250,000: a staggering sum. Hussain also offered to buy him a new BMW, a holiday in Puerto Rico, and a barber shop to set him up in his own business. The other three were also offered thousands of dollars in what must have seemed a miraculous windfall.

Both Williams men had done time in jail and were struggling. Onta Williams, the son of a crack addict mother, had started dealing drugs at 14. Meanwhile Payen, of Haitian origin, was possibly schizophrenic. He urinated in bottles in his bedroom and, when told of a trip to Florida as reward, said he could not go because he had no passport.

In meetings discussing the plot, Payen said little; he just devoured the copious free food Hussain bought. It is not a portrait of radical Islamists. It is a sad picture of life in an urban ghetto.

Blustering fantasist

Yet the FBI treated the gang, especially Cromitie, as dedicated fanatics. Cromitie certainly disliked Jews. "All the evil in this world is due to the Jews," Cromitie told Hussain. But Cromitie also told Hussain he believed President Bush was the anti-Christ and he wanted to kill him "700 times".

Cromitie falsely claimed to have visited Afghanistan. He said he stole guns from his job at Walmart, yet the shop did not sell firearms. He said he had been jailed for murder and thrown bombs at police stations: all lies.

Cromitie seemed less a terrorist and more a blustering fantasist. Indeed, away from the company of Hussain, there is little sign Cromitie did anything for the plot. When Hussain gave him a camera and told Cromitie to reconnoitre targets, he promptly sold it.

He knew little about Islam; it was Hussain who tried to educate him about jihad. Hussain complained bitterly his pupil was doing nothing. "You've not started the first step, brother. Come on," Hussain griped on tape.

In fact, Cromitie tried to ditch Hussain. For weeks on end Cromitie pretended to leave Newburgh to avoid him. Cromitie ignored Hussain's phone calls, deleted voice mails and pretended not to be in when Hussain came around his house. He stopped going to the mosque.

Only when Cromitie lost his job, and became desperate for money, did he contact Hussain again. "I told you, I can make you $250,000, but you don't want it, brother," Hussain told him.

Now Cromitie agreed and set about finding lookouts. "Ok, fuck it. I don't care. Ah, man. Maqsood, you got me," he said, using Hussain's fake name.

Even further into the plot – when Cromitie again told Hussain he did not think he could do it – Hussain said his overseas terrorist "brothers" might cut his head off. Cromitie came back on side.

The sheer scale and proactive nature of Hussain's actions has shocked legal experts, Muslim groups and civil rights organisations. They say it went far beyond a fair use of resources in neutralising a real threat. Not only was the entire plot fake, but it seemed only Hussain's Islamic coaching, talk of cash rewards and constant attention was keeping it alive.

But then Hussain was no normal informant. The entire FBI entrapment strategy in post-9/11 America has drawn fire for using informants with criminal records, shady pasts, financial incentives or a record of deception. Hussain had all four.

"He is a brilliant con man. He could con people about anything," said Steve Downs, a lawyer with Project Salam, which campaigns on entrapment cases.

At trial, Hussain's shocking past emerged. He claimed to have been arrested on murder charges in Pakistan. He admitted entering the US on a fake British passport. He had fraud convictions for a driving license scam. Indeed, he became an FBI informant in exchange for help with those charges.

He claimed to be poor, yet received mysterious sums of money from Pakistan. In 2009 and 2010 he got at least $250,000 that way. He explained having two luxury cars with a bizarre story that Pakistani leader Benazir Bhutto gave them to his family on a trip to New York.

He also claimed he never offered Cromitie a quarter of a million dollars, saying the phrase "$250,000" was a secret code name for the plot. Then he confessed he had not told either his FBI handlers or Cromitie of the code's existence; only he knew about it.

During the entire investigation, he earned $100,000 from the FBI in wages and expenses. In a tough economy, that is well-paid work for a convicted fraudster.

Yet Hussain was the sole personal witness for the FBI. His reports of what Cromitie had talked about were taken as truth, even though Hussain did not record the first four months of their meetings. And, once he began recording, the FBI unusually allowed him to switch the tape on and off. "They gave him a real long leash. He could do whatever he wanted," said Downs.

Therefore, there are large, unexplained gaps in the tapes, including the final minutes of the plot itself as the bombs were put in position. Hussain claimed - as he often did – that equipment malfunctioned at the vital moment.

Shakespearean buffoonery

Even Judge Colleen McMahon – who put the Newburgh Four behind bars – slammed the FBI. "Only the government could have made a terrorist out of Mr Cromitie, a man whose buffoonery is positively Shakespearean in its scope," she said in court. She added: "I believe beyond a shadow of a doubt that there would have been no crime here except the government instigated it, planned it and brought it to fruition."

Those comments did not appease Alicia McWilliams, David Williams's aunt. "This was a movie script, written by the FBI," she fumed.

But it is hard to drum up support. Newburgh showed that for a jury the mention of the word "terrorism" can override legal concerns. It also makes campaigning for the Newburgh Four – and other Muslims caught in entrapment schemes – difficult. "Fear does that to people. When you say "terrorism", that is a powerful word. Even half of my family don't want anything to do with this," McWilliams said.

But what were the Newburgh Four thinking? In letters sent from jail, David Williams claimed they were intent on eventually robbing Hussain. Williams had a brother in need of a liver transplant and he said he wanted cash for that. It is a story McWilliams believes.

Muhammad also thinks it might be possible. "Maybe they thought they were playing Hussain for money. But they were the ones being played," the imam said. Others are not so sure.

Greenburg believes the men likely knew what they were doing, but were interested in cash, not religion. "From the evidence, they believed in the plot. But they didn't believe in jihad," she said. For prosecutors, that was enough to justify the whole scheme. "Ordinary people … would have known better. For Pete's sake, they would have called the cops when they heard there was a terrorist in town. These four men? They didn't give it a second thought," said prosecutor David Raskin in court.

However, that concept disturbs civil rights experts and legal figures, who dislike that FBI informants can offer money to people in return for committing crimes and then prosecute them. "I'm sure you could find hundreds of people, unfortunately, who would agree to commit very bad crimes for money," defence lawyer Mark Gombiner said.

Some say the FBI has now softened its tactics in the wake of the fallout from Newburgh. Last month, a sting by New York police netted suspected terrorist Jose Pimentel allegedly building a bomb with the help of an NYPD informant. Yet the FBI declined to get involved. It did not consider the man a legitimate threat. "The Newburgh case has had an impact. I know that," said Greenberg.

But for now the Newburgh Four remain in jail. Their families desperately hope they will be successful in next year's appeal. And Hussain? With two successful cases behind him, he is an experienced FBI asset. He has now disappeared from those who knew him in Albany and Newburgh. "Maybe he got a new assignment from the FBI," said Downs.