Armed with Kalashnikovs and warming their hands at an open wood fire, the Albanian policemen guard the narrow, dirt road that leads down to Kakome Bay. The idyllic, horseshoe-shaped inlet on the edge of the Ionian Sea is at the centre of a bitter row between local villagers and the government and has become a symbol of the painful transition from communism to an unfettered free-market economy.

Although the road is closed, a goat-track over the hills behind the nearby village of Nivica offers a chance to see just why the bay provokes such strong emotions. The site of a 14th century monastery, the bay's sheltered sea is pure turquoise and the only sounds are of goat bells and sea birds. Used by generations of villagers for grazing their herds and latterly for collective farming, the bay's existence was barely known outside the area until the end of Albanian communism in 1992.

Now Club Med is in talks with a local developer about creating a holiday village for 700 people. The Nivica villagers are furious. They claim the land belongs to them, and say they have documents stretching back to the days before King Zog to prove it.

Last month, as the developer's bulldozers tried to move in they were met by angry protesters. When the villagers made it clear that they were not budging, the government sent 600 armed special forces. There were violent clashes, seven villagers were arrested and two, including the mayor, Vladimir Kumi, are now under house arrest.

"They had snipers in the hills," said Mr Kumi. "I told the young people to throw away their sticks and we would just sit down and they would have to drag us away. This was where God placed us and we have sworn an oath that we will protect our land whatever the cost,"

"Even the Germans didn't behave like that," said Vasilika Kumi, the mayor's mother, who was a child during the German occupation of the second world war. A memorial in the village carries the names of dozens of villagers who died during that period, some as a result of reprisals for an ambush of German troops. "At least the Germans never bothered the women," she said.

Those arrested have been charged with planning an illegal protest and blocking the public highway. Mr Kumi says his house arrest is indefinite.

"Until the day I die, I will remember the screams of the women," said Sofolki Papadhima, 78, talking about the protest, not the German occupation. "They came with bulletproof vests - why would they need those? People stayed day and night in the rain to protest and behaved in a democratic way, but they sent no one to talk to us."

Mr Kumi said the villagers were not opposed to tourism on the bay, but wanted to be consulted and reimbursed and to choose the best plan. Around 900 locals, more than two-thirds of the village, had left during the past decade to find work abroad, and a holiday development could bring them back.

Albania is widely regarded as having great tourist potential, not least because its five decades of isolation under the communism of Enver Hoxha has meant that it has not yet suffered the development ravages of other tourist spots.

The French-based Club Med had no comment on the dispute beyond a statement: "Club Med are in negotiations with a company in Albania. However, no final agreement has been reached."

Mayor Kumi produced documentation dating back to 1876 indicating that ownership of the bay was held by villagers. He also had post-communist documents from 1992 affirming that the villagers had equal shares. "We have rights under both the old system before King Zog and under the new system," he said.

He believes the Socialist prime minister, Fatos Nano, has an involvement in the scheme. "How else would they have sent 600 special forces?" he asked. "I believe he must be involved." They say it is highly suspicious that the scheme was given the go-ahead without their knowledge.

For the government, the clashes are an embarassment as it prepares for a general election, due to take place in the summer, and seeks to prove to the EU that Albania is a suitable future member. "The police have removed people and work has started," said a public order ministry spokesman of the dispute. "No one has been badly hurt."

In Nivica, the villagers are pinning their hopes on their protests succeeding, or on the election of the opposition free market Democratic party, which lost power in the wake of the pyramid-selling scandal of 1997. Whatever happens, tourism seems likely to change the face of the coast.

"There are 13 other tourist villages waiting to see what happens with us," said Klement Papdhima, the village secretary who has been helping to organise the protests. Already dozens of new hotels are being thrown up in nearby Saranda, a popular resort for Albanians, and there are fears locally that uncontrolled development could irreparably damage one of the world's most spectacular landscapes.

"We want to avoid what happened to Spain," said one tourist guide in Saranda. "But too many people here are already just throwing up hotels to launder their money."

There is one glint of hope in the row. Just to the south of Kakome Bay lies Butrint, an archaeological treasure trove which contains well-preserved Greek, Roman, Byzantine and Venetian remains stretching back to the fourth century BC. It has been declared a world heritage site, so no new buildings can be constructed there. Day-trippers currently come from Corfu and the hope is to encourage eco-friendly tourism so that they will stay longer.

Professor Richard Hodges of the University of East Anglia's Institute of International Archaeology, has been supervising digs there with the Butrint Foundation for the past decade. He hopes other parts of the coast can be treated with the same care. Of Kakome Bay, he said: "It should be kept as a resource. It is the most blissful place." Meanwhile Mayor Kumi and the village that defied the German army of occupation are making it clear that the battle has only just begun.