John Downey is believed to have carried out a 1982 attack in London's Hyde Park that killed four cavalry soldiers but his trial collapsed last year after it emerged prosecutors had sent him a letter guaranteeing he would never face trial.
The letter was one of 228 sent out to militants as part of negotiations to keep the peace in Northern Ireland.
Giving evidence to the parliamentary committee investigating the scheme, Blair said that only people deemed by prosecutors to have a lack of evidence against them were meant to have received the letters.
Blair apologised to the victims' families for the "misapplication of the scheme" that led to Downey being freed.
"In hindsight, this thing that began as a few cases would have been better being pulled into a proper scheme," he told the Northern Ireland Affairs committee.
"I apologise to the people who have suffered as a result of that."
But Blair defended the policy in the face of heavy criticism from committee members over whether it was actually vital to the negotiations.
"I can't prove I'm right but you can't prove I'm wrong."
Blair, who was prime minister between 1997 and 2007, argued that the republican party Sinn Fein would have walked away from the talks.
