The court also held that permission to prosecute Pandey, who was government servant, was not taken by the investigating officer from the state before filing of the charge sheet against him, though it was required under section 197 of the CrPC.
Special court judge J K Pandya allowed Pandey's discharge application on the grounds that there was no evidence against him related to the kidnapping and murder of Ishrat Jahan (19) and three others.
Shamsad Pathan, the lawyer for Jahan's mother, said they would challenge Pandey's discharge in the high court.
In his defence, Pandey had argued that permission to prosecute him was not granted to the CBI which went against the provisions of section 197 of the CrPC.
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As per the section, a court cannot take cognisance of any offence alleged to have been committed by a government servant without previous sanction of the government concerned.
The court today said that none of the witnesses accused Pandey of murdering and kidnapping the victims. It also said that the statements given by the witnesses were contradictory.
The city crime branch officials had gunned down Ishrat Jahan, who hailed from Mumbra near Mumbai, her friend Javed Sheikh alias Pranesh, Zeeshan Johar and Amzad Rana on June 15, 2004 on the outskirts of the city.
Gujarat police had claimed that Jahan and others had terror links and had plotted to kill the then chief minister Narendra Modi.
He was ADGP-CID (Crime) when he was arrested by the CBI in July 2013 following his surrender before a court.
In February 2015, just days after he was granted bail by the special CBI court, Pandey was appointed as the additional director general of police.
Pandey was later promoted as the in-charge DGP of Gujarat but resigned on a PIL filed by former top cop Julio Ribeiro challenging his appointment as well as service extension while being an accused out on bail. The Supreme Court had allowed the government to accept Pandey's resignation.
A Special Investigating Team (SIT) constituted by the high court to investigate the case had concluded that it was an extra-judicial killing, following which the HC transferred the case to the CBI.
In a first charge sheet filed in 2013, the CBI named seven Gujarat police officers as accused, including Vanzara and G L Singhal, besides Pandey. They were charged with kidnapping, murder and conspiracy.
Shamsad Pathan, who also represents Sheikh's father, said the verdict went against the orders of the Supreme Court and the High Court.
"We will challenge Pandey's discharge in the high court. Witnesses' statements before a magistrate are the most important evidence, and witnesses told the magisterial court that Pandey was present in the meeting where the (encounter) conspiracy was hatched.
"Today's verdict of the CBI court also goes against the previous orders of the Supreme Court and High Court that held that the encounter was fake," said Pathan.