Stonehouse allegedly began spying for Czechoslovakia in 1962. In a meeting with Harold Wilson in 1969, Stonehouse was informed of assertions that he was a Czechoslovak Secret Service Agent. The informant was a defector from the Czechoslovak StB Secret Service, who had been debriefed by the US Security Services. At that time, Stonehouse successfully defended himself. In 2009, the spy allegation was substantiated in the official history of MI5, 'The Defence of the Realm' (2009) by Cambridge historian Christopher Andrew. In December 2010, it was revealed that, in 1980, then-Prime Minister Margaret Thatcher had agreed to cover up revelations that Stonehouse had been a Czechoslovak spy since the 1960s as there was insufficient evidence to bring him to trial. Until Ray Mawby, briefly a member of a Conservative Government, was exposed in June 2012, Stonehouse was the only Minister known to have been an agent for the former Eastern bloc.
Stonehouse stood for and was elected to the Walsall North constituency in February 1974. With Labour at he time governing in minority, another election was called in September, and Stonehouse was re-elected with an increased majority of nearly 16,000 in the October 1974 election, where Labour won a narrow majority. His last Parliamentary contribution before his disappearance was at Prime Minister's Questions on 14 November, then he flew to Miami, Florida on 17 November of that year.
After 1970, Stonehouse set up various companies in an attempt to secure a regular income. By 1974, most of these were in financial trouble, and he had resorted to deceptive creative accounting. Aware that the Department of Trade and Industry was looking at his affairs, he decided that his best choice would be to flee. Secret British government documents, declassified in 2005, indicate that Stonehouse spent months rehearsing his new identity, that of Joseph Markham, the deceased husband of a constituent.
Stonehouse maintained the pretence of normality until he faked his death on 20 November 1974, leaving a pile of clothes on a beach in Miami Beach to make it appear that he had gone swimming and had drowned, or possibly had been killed by a shark. He was presumed dead, and obituaries were published in British newspapers despite the fact that no corpse had been found. In reality, he was en route to Australia, some 9,000 miles away, hoping to set up a new life with his mistress and secretary, Sheila Buckley.
Using false identities, Stonehouse set about transferring large sums of money between banks as a further means of covering his tracks. Under the name of Clive Mildoon, he deposited A$21,500 in cash at the Bank of New Zealand. The teller who handled the money later spotted "Mildoon" at the Bank of New South Wales. Inquiries led the teller to learn that the money was in the name of Joe Markham and he informed the local police. Stonehouse spent a while in Copenhagen with Sheila Buckley, but later returned to Australia, unaware that he was now under surveillance. The police initially suspected him of being Lord Lucan, who had disappeared a fortnight before Stonehouse, following the murder of his children's nanny, Sandra Rivett. Investigators noted that the suspect was reading British newspapers that also included stories attacking the 'recently deceased' John Stonehouse. They contacted Scotland Yard, requesting pictures of both Lord Lucan and Stonehouse. On his arrest, the police instructed him to pull down his trousers in an attempt to establish whether or not he was Lord Lucan, who had a six-inch scar on the inside of his right thigh.
Stonehouse was arrested in Melbourne on 24 December 1974. He applied for the position of Steward and Bailiff of the Chiltern Hundreds while still in Australia (one of the ways for an MP to resign), but decided not to sign the papers. On 17 July 1975, Stonehouse was extradited to the UK, escorted by Scotland Yard officers. He had tried to obtain offers of asylum from Sweden or Mauritius. He was remanded in Brixton Prison until August 1975 when he was released on bail. He continued to serve as an MP.
On 20 October 1975 he made a personal statement to the House of Commons, stating his reasons for his disappearance, his first Parliamentary oration since his disappearance almost a year earlier "The explanation for the extraordinary and bizarre conduct in the second half of last year is found in the progressions towards the complete mental breakdown which I suffered."
This breakdown was analysed by an eminent psychiatrist in Australia and was described by him as psychiatric suicide. It took the form of the repudiation of the life of Stonehouse because that life had become absolutely intolerable to him. A new parallel personality took over, separate and apart from the original man, who was resented and despised by the parallel personality for the ugly humbug and sham of the recent years of his public life. The parallel personality was uncluttered by the awesome tensions and stresses suffered by the original man, and he felt, as an ordinary person, a tremendous relief in not carrying the load of anguish which had burdened the public figure.
The collapse and destruction of the original man came about because his idealism in his political life had been utterly frustrated and finally destroyed by the pattern of events, beyond his control, which had finally overwhelmed him.
Although unhappy with the situation, the Labour Party did not expel him. Their Parliamentary majority was very narrow. On 4 April 1976 Stonehouse attended a St George's Day festival hosted by the English National Party, he later confirmed he had joined the party, making Labour a minority government.
Stonehouse conducted his own defence on 21 charges of fraud, theft, forgery, conspiracy to defraud, causing a false police investigation and wasting police time. His trial lasted 68 days. On 6 August 1976, he was convicted and sentenced to seven years in prison for fraud, and received a criminal bankruptcy order. He agreed to resign as a Privy Counsellor on 17 August 1976, becoming one of only three people to resign from the Privy Council in the 20th century. Stonehouse tendered his resignation via the Chiltern Hundreds route from the House of Commons on 27 August 1976. The subsequent by-election was won by Robin Hodgson, a Conservative. In October 1976, Stonehouse was declared bankrupt.
Stonehouse was imprisoned in HM Prison Wormwood Scrubs. On 30 June 1977, the House of Lords refused his appeal against five of the charges of which he was convicted. While he was in prison, he complained that the prison workshop where he worked played pop music on the radio station. When his health deteriorated, he was moved to HM Prison Blundeston in Suffolk.
On 14 August 1979, Stonehouse was released early from prison because of good behaviour and because he had suffered three heart attacks; he had the first on 18 April 1977, a second one four days later, and a massive heart attack on 13 August 1978. On 6 September 1978 Stonehouse suffered a coronary ischemia attack which required him to spend three days in hospital. He underwent open heart surgery on 7 November 1978 which lasted for six hours.
On 25 March 1988, Stonehouse collapsed on set during an edition of Central Weekend in Birmingham during the filming of a programme about missing people. He was given emergency medical treatment at the studio and an ambulance was called. He was diagnosed as having suffered a minor heart attack and kept in the city's general hospital overnight. Just under three weeks later, early on 14 April, he suffered a massive heart attack at his house at Dales Way in Totton, Hampshire, where he had moved six months earlier, having lived in London since his release from prison, his last address there having been at 20 Shirland Mews. This time Stonehouse could not be saved, and he died in hospital at 2.30am. He was cremated in Bassett Green, Southampton, on 22 April 1988. The former MP Bruce Douglas-Mann paid tribute. In 1989, his fourth novel was published posthumously. He left under £70,000 according to his will published on 17 August 1988.