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UK chancellor Rachel Reeves is to restore winter fuel payments to all but 2mn pensioners with incomes of more than £35,000, in a U-turn that will cost the Treasury £1.25bn.

Reeves announced the retreat ahead of this week’s spending review as she attempted to garner some positive headlines at a time of a tight squeeze on some public service budgets.

The chancellor was forced into a U-turn by Labour’s drubbing in English local elections last month and the subsequent backlash from the party’s MPs at Westminster.

Under the revised plan, about 9mn pensioners this winter will receive the fuel payment, which is worth either £200 or £300.

About 2mn pensioners with taxable incomes of more than £35,000 would also receive the payment but the money will be recovered by HM Revenue & Customs.

Reeves’ U-turn leaves her with a £1.25bn-a-year hole in the public finances by the end of the decade compared with the plan she set out in July last year.

The chancellor said on Monday that the costs would be accounted for in her autumn Budget and that she would take steps to fill the fiscal hole. “This will not lead to permanent additional borrowing,” said the Treasury.

Many economists believe Reeves will be forced to raise taxes in the autumn, not least because Labour MPs are putting pressure on her to scale back her plans to cut welfare payments.

Under Reeves’ original plan, only the poorest pensioners — those in receipt of pension credit — would have continued to receive the winter fuel payment. About 10mn were set to lose the subsidy.

The revised plan will hit about 2mn pensioners, who will be paid the subsidy automatically before having it recouped, either through their employers and pension providers, or through annual tax returns.

The Treasury argued that these 2mn pensioners were living “well above the income level of pensioners in poverty” and that the £35,000 threshold was broadly in line with average earnings.

Money will be clawed back from individuals rather than households, meaning couples with one person under the threshold would still receive a partial payment even if their partner’s earnings were too high, the Treasury said.

“Targeting winter fuel payments was a tough decision but it was the right decision because of the inheritance we were left by the previous government,” said Reeves.

“It is also right we continue to means-test this payment so that it is targeted and fair, rather than restoring the eligibility to everyone, including the wealthiest.”

The Treasury said the final scheme for this winter would save £450mn compared with the original programme, which was a universal benefit paid to all pensioners.

But some experts have warned the U-turn could mean the government makes very limited savings because the initial cut last year spurred more pensioners to sign up for pension credit.

There were about £230mn of new claims for pension credit after the government initially encouraged applications to offset the impact of the cuts.

Conservative leader Kemi Badenoch said: “This humiliating U-turn will come as scant comfort to the pensioners forced to choose between heating and eating last winter. The prime minister should now apologise for his terrible judgment.”

Reform UK leader Nigel Farage, who had called on the government to reverse the cut, said his party could “claim credit” for the U-turn. “I think we have made the political weather on this one,” he told party supporters in Wales on Monday.

Additional reporting from Anna Gross in Port Talbot