MANILA—When Robert Rice Jr. clinched a deal to sell secondhand military helicopters to the Philippines, it seemed like a golden opportunity to tap a new and potentially lucrative market.

Instead, the sale broke down, with Mr. Rice facing bribery accusations that he says are baseless and with the Philippine government terminating Mr. Rice’s $28 million contract part-way through, citing delivery headaches. As a result, he said, he has had to lay off workers in Sacramento, Calif.

The controversy has become a major setback for Philippine defense officials, whose attempts to modernize the country’s nearly obsolete military were already floundering. Now defense officials in charge of procurement fear that potential suppliers will steer clear of the Philippines, the defense department said, deterred by Mr. Rice’s problems and by corruption concerns.

The affair has sparked a legislative inquiry, a justice department investigation and a string of lurid newspaper headlines.

Mr. Rice, who faces no criminal charges, has a message to other U.S. firms interested in doing business in the Philippines: “I’ve never experienced anything like this in my life. They have to be incredibly careful.”

Under President Benigno Aquino III, the Philippine government has sought to increase military spending as it faces off against China in South China Sea territorial disputes.

However, red tape has stalled this push for modernization, with senior officers telling a Philippine Senate hearing in late July that of 30 equipment programs worth roughly $1 billion initiated in 2012, only two have been properly implemented so far. The Senate, concerned with these delays, has been investigating the defense department’s recent procurement activities to determine why so little equipment has been bought.

Among the stalled procurement efforts was Manila’s deal with Mr. Rice. A former engineer in the U.S. Air Force, Mr. Rice established Rice Aircraft Services Inc. in 2003. His firm refurbished and resold retired aircraft like the UH-1 Huey—an iconic Vietnam War-era utility helicopter that is still used as a reliable workhorse by many air forces world-wide.

When the Philippines announced plans to buy 21 refurbished Hueys at a price of $27.8 million in 2012, Mr. Rice knew he could source the helicopters in Germany and he won the contract. The helicopters started arriving in the Philippines in June 2014.

But by late last year, Mr. Rice’s relationship with his local Filipino business representative, Rhodora Alvarez, had soured. Ms. Alvarez told a recent Senate hearing that she had found out that Mr. Rice had agreed to pay Philippine defense officials 15% of the contract value—about $4.2 million—to accept substandard helicopters.

“We categorically deny this,” the defense department said of Ms. Alvarez’s accusations, insisting the helicopter procurement had been legal and graft-free.

Mr. Rice says Ms. Alvarez was trying to extort $4.2 million from him and only made the bribery allegations to cover herself after he told defense officials about what she was trying to do.

During televised Senate hearings in July, Mr. Rice displayed what he said was a contract drawn up by Ms. Alvarez demanding 15% of the helicopter deal. Ms. Alvarez said the contract was drafted by Mr. Rice, and that she had refused to sign it.

Ms. Alvarez has denied any wrongdoing and isn’t charged with any crime. She is being sued for libel by one of the defense officials she has accused of taking bribes, but doesn’t face any charges relating to Mr. Rice’s allegation of extortion.

A State Department official said the U.S. is aware of Mr. Rice’s case but declined to comment specifically on it. “The U.S. Government clearly expects all U.S. individuals and companies doing business overseas to comply with all applicable laws and regulations,” the official said.

The U.S. remains committed to strong relations with the Philippines, the official said. “The United States and the Philippines have a strong, enduring, and multidimensional security alliance,” the official said. “Our rock-solid commitment to the Philippines and to the Mutual Defense Treaty stands.”

The Philippines has a checkered past when it comes to military procurement. In 2013, London-based corruption monitor Transparency International said defense deals in the Philippines are at “very high risk” of corruption, due to the workings of the defense establishment and weak oversight mechanisms.

Since then, the Philippines has made serious efforts to clean up its defense procurement procedures, according to Katherine Dixon, director of the organization’s defense and security program. The defense department said it had adopted a zero-tolerance approach to graft under Mr. Aquino.

These anticorruption measures have contributed to the slow rate of progress at the defense department concerning modernization, according to Jose Antonio Custodio, a Manila-based defense consultant.

To refute Ms. Alvarez’s claims that the Hueys obtained from Mr. Rice don’t work properly, the Philippine Air Force flew seven of them in a public demonstration in July. But this proved nothing, Ms. Alvarez told The Wall Street Journal. “I never said they couldn’t fly. I said they weren’t mission capable,” she said, promising to provide documentary evidence of the aircraft’s defects at the next Senate hearing.

The Philippine Air Force dismissed her allegations. “Absolutely, they are fully mission capable,” military spokesman Lt. Col. Noel Detoyato said of the seven helicopters.

While the defense department said it doesn’t suspect Mr. Rice of any wrongdoing, it terminated his contract in March after only seven out of 21 aircraft had been delivered, due to what it said were missed delivery deadlines. Mr. Rice said the late deliveries were beyond his control; he blamed congestion at Manila’s ports.

But Mr. Rice says the controversy surrounding the deal was likely the real reason for its cancellation. He has asked the defense department to reverse its decision. For now, the remaining 14 helicopters are being stored in a hangar north of Manila.

For its part, the hard-pressed Philippine military hopes the impasse between Mr. Rice and the defense department can be resolved soon. “We certainly need the helicopters,” said Lt. Col. Detoyato.

—Felicia Schwartz in Washington contributed to this article.

Write to Trefor Moss at [email protected]