The commission should now apologise to former High Commissioner to London Derek Leask and pay him compensation, Mr Paterson said in his report.
Mr Leask complained to the Ombudsman in June 2014 after he was criticised in the Rebstock inquiry into the leaking of documents about a planned restructure of the Ministry of Foreign Affairs and Trade (MFAT).
Mr Paterson said today that the inquiry, led by Dame Paula, contained "numerous flaws". Mr Leask was not responsible for the leaks at the heart of the inquiry, and the flawed report caused "significant damage" to his reputation and resulted in "serious, unwarranted and adverse professional, personal and financial consequences for him".
Mr Leask welcomed the Ombudsman's findings today, saying that the findings in the Rebstock report had been "rubbished".
"It is good to have the slur on my reputation removed," he said.
"Today's findings by the Ombudsman go beyond the vindication of my actions. The Ombudsman's report suggests that the [State Service Commission] investigation was out of control from start to finish."
He said he had been forced to defend himself against accusations that were outside the original scope of the inquiry, and were later proved wrong.
The former diplomat, who served at MFAT for 40 years, said he had no choice but to hire lawyers to deal with "an aggressive SSC-run process which resulted in personal public attacks". He was determined that the commission was held to account.
"That is why I appealed to the Ombudsman. And now I am finally vindicated. It has been a long fight but worth it."
State Services Commissioner Iain Rennie said the commission was discussing "potential redress" with Mr Leask, but he could not comment further.
Mr Rennie said he accepted that the way the inquiry dealt with Mr Leask "could have been better".
However, he did not agree with the Ombudsman's finding that Dame Paula had strayed outside the terms of reference in the way it dealt with Mr Leask.
"Terms of reference for investigations need to be specific enough to give clarity to all involved, while giving enough scope for the investigator to pursue information and lines of inquiry that present themselves during an investigation," he said.
The Ombudsman found that Mr Rennie had falsely implied that Mr Leask had leaked information from MFAT in an interview with RNZ.
Mr Rennie said today that he had apologised in writing to Mr Leask for the error.
"I am very happy to reiterate my apology here," he said.
At the time of the inquiry, Foreign Minister Murray McCully said a "small number of individuals" had engaged in "unprofessional and disreputable conduct".
The minister was not criticised in the Ombudman's report.
Labour's state services spokesman Kris Faafoi said the Ombudsman's findings confirmed that Mr Leask and former diplomat Nigel Fyfe had been treated "disgracefully".
Mr Paterson's report was "disturbing reading", he said. The fact that it exceeded its terms of reference and ignored relevant evidence "paints a picture of a kangaroo court".
Mr Faafoi urged the commission to make a public apology to Mr Leask, and said the Government had to change the way it investigated senior Government officials.
The Rebstock inquiry was launched in May 2012 after Labour MP Phil Goff, then a foreign affairs and trade spokesman, made references in Parliament to content from confidential Cabinet documents.
It was the latest in series of leaks from MFAT about its controversial restructuring. The inquiry lasted 18 months and cost more than $500,000.
