(Fortune Magazine) -- An ongoing battle between South Korean prosecutors and a U.S. private-equity fund looking to cash out a $4 billion profit appears to be making foreign firms skittish about doing M&A deals in Korea.

Since May, prosecutors there have held up attempts by a Dallas-based private-equity fund called Lone Star to sell the Korea Exchange Bank, which Lone Star acquired in 2003, and make a $4 billion profit. Resentment had built up after American funds reaped massive profits on distressed banks they purchased following the late 1990s Asian financial crisis. The Carlyle Group netted $700 million on one, and Newbridge Capital made $1.1 billion on another.

Many Koreans felt the government was giving away the store to foreigners. Politicians began attacking foreign funds, and the National Assembly closed the loopholes that foreigners were using to exit tax-free.

Now Korean prosecutors are blocking Lone Star's deal while they investigate whether the U.S. firm conspired with insiders to cook KEB's books in order to have the bank declared "troubled" - and therefore eligible for a takeover. Managing director John Grayken denies any conspiracy and says his was the only firm interested in the undercapitalized bank. "The economy is a lot better off that we did that deal than it otherwise would have been," he says.

Prominent investors such as Mark Mobius of Templeton Asset Management have spoken out about Korean uncertainty in the wake of the Lone Star case. In response, perhaps, Korea's Minister of Commerce, Industry, and Energy flew all the way to New York City this summer to court U.S. investors, vowing that his government "will not adopt measures that are in any way detrimental to foreign investors."

Non-Korean funds are welcome, insists the head of the Korean Trade Investment Promotion Agency, Chung Tong-Soo, who denies that nationalism has influenced Lone Star's treatment. He notes that outside direct investment in Korea is up about 6% and dismisses the M&A slowdown. "Distressed situations are harder to find," he says, adding that the nascent Korean fund industry is "competing with the foreigners now, and the opportunities for foreigners are fewer." As global investors watch Lone Star's treatment, even those opportunities may now go begging.