The 59-year-old became the first former French president to be taken into custody when he was quizzed under police guard over allegations that he tried to use his influence to thwart an investigation of his 2007 election campaign.
French prosecutors later announced that Sarkozy had been placed under formal investigation, meaning his case will be examined by a judge who will determine if whether there is sufficient evidence for him to be charged.
News of the formal investigation is the latest blow to Sarkozy's hopes of a 2017 political comeback after his 2012 election defeat by Socialist rival Francois Hollande.
Sarkozy is being investigated on suspicion he used his influence to secure leaked details of an inquiry into alleged irregularities in his victorious 2007 election campaign.
He is accused of influence peddling, corruption and benefiting from 'the breach of professional secrets,' the prosecutor's office said.
Influence-peddling can be punished by up to five years in prison and a fine of 500,000 euros (around £400,000).
Sarkozy was informed of the formal investigation during the early hours this morning by investigating magistrates after he had been held in police custody until nearly midnight on Tuesday.
He arrived at police offices in the Paris suburb of Nanterre just after 8am and was placed ‘garde a vue', a legal term meaning he is a suspect in a criminal inquiry.
Sarkozy's detention over accusations of influence-peddling at France's highest court followed the arrest on Monday of two magistrates and Sarkozy's lawyer, Thierry Herzog.
The former leader is said to have offered one of the judges, Gilbert Azibert, a job in return for inside information on the so-called Bettencourt affair.
This was a case in which Sarkozy was accused of illegally accepting millions from Liliane Bettencourt, the l'Oreal heiress and France's richest woman, for his election campaign in 2007. The case has now been dropped.
Officials also believe Sarkozy was illegally tipped off that his phone had been tapped by those investigating whether he received money from the late Colonel Gaddafi of Libya.
Sarkozy is said to have used a special mobile phone, registered under the name ‘Paul Bismuth', to speak to his lawyer because he suspected he had been bugged.
Soon after he stepped down as president in 2012, the Paris home he shares with his third wife, former model Carla Bruni, was raided by anti-corruption police.
As president, he had enjoyed immunity from prosecution, but this came to an end with his defeat by Socialist candidate Francois Hollande. Sarkozy, who has indicated he will run for re-election in 2017, has always insisted that he is innocent of any wrongdoing.
But yesterday's developments are a disaster for his political ambitions as he faces being formally charged with influence-peddling, which carries a maximum prison sentence of a decade.
His remand in custody is unprecedented. Jacques Chirac, once Sarkozy's mentor and his predecessor as president, was found guilty of corruption in 2011.
But he was never held in custody and received only a two-year suspended sentence for embezzling public funds when he was mayor of Paris.
Conservative friends of Sarkozy leapt to his defence, with MP Christian Estrosi saying the judiciary ‘have never imposed such treatment on a former president, with such a surge of hate'.
Others suggested the arrest was politically motivated, with Left-wing officials trying to humiliate him. But there is no doubt Sarkozy's behaviour as president raised suspicions.
Within a few months of coming to office in 2007, he had invited Colonel Gaddafi on a state visit to Paris, on which he was honoured as a ‘Brother Leader'. Alleged evidence, including statements from leading Libyans, has suggested more than £25million was transferred from Gaddafi's account to Sarkozy's coffers.
Yet it was Sarkozy, with Prime Minister David Cameron, who in 2011 ordered the airborne assault on Gaddafi that eventually led to his overthrow.
In a separate case, relatives of those killed in a bombing in Pakistan in 2002 have filed a complaint against Sarkozy for allegedly violating a duty to secrecy during an official investigation.
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