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[[File:Sinking_of_the_Confederate_ship_CSS_Alabama.jpg|thumbnail|left|300px|Sinking of the CSS Alabama by the USS Kearsarge in 1864]]__NOTOC__

The controversy began when Confederate agents contracted for warships from British boatyards. Disguised as merchant vessels during their construction in order to circumvent British neutrality laws, the craft were actually intended as commerce raiders. The most successful of these cruisers was were the Alabama, which was launched on July 29, 1862. It captured 58 Northern merchant ships before it was sunk in June 1864 by a U.S. warship off the coast of France. In addition to the CSS Alabama, other British-built ships in the Confederate Navy included the Florida, Georgia, Rappahannock, and Shenandoah. Together, they sank more than 150 Northern ships and impelled much of the U.S. merchant marine to adopt foreign registry. The damage to Northern shipping would have been even worse had not fervent protests from the U.S. Government persuaded British and French officials to seize additional ships intended for the Confederacy. Most famously, on September 3, 1863, the British Government impounded two ironcladironclads, steam-driven “Laird rams” that Confederate agent James D. Bulloch had surreptitiously arranged to be built at a shipyard in Liverpool.

The United States demanded compensation from Britain for the damage wrought by the British-built, Southern-operated commerce raiders, based upon the argument that the British Government, by aiding the creation of a Confederate Navy, had inadequately followed its neutrality laws. The damages discussed were enormous. Charles Sumner, Chairman of the Senate Foreign Relations Committee, argued that British aid to the Confederacy had prolonged the Civil War by 2 years, and indirectly cost the United States hundreds of millions, or even billions of dollars (the figure Sumner suggested was $2.125 billion). Some Americans adopted this argument and suggested that Britain should offer Canada to the United States in compensation. Such proposals were not taken seriously by British statesmen, but they convey the passion with which some Americans viewed the issue.

After years of unsuccessful U.S. diplomatic initiatives, a Joint High Commission meeting in Washington, D.C. during the early part of 1871 arrived at the basis for a settlement. The British Government expressed regret for its contribution to the success of Confederate commerce raiders. This agreement, dated May 8, 1871, and known as the Treaty of Washington, also established an arbitration commission to evaluate the merit of U.S. financial claims on Britain. In addition, the treaty addressed Anglo-American disputes over boundaries and fishing rights. The arbitration commission, which issued its decision in September 1872, rejected American claims for indirect damages, but did order Britain to pay the United States $15.5 million as compensation for the Alabama claims.

In the north, fears of a resurgent United States and calls by some U.S. politicians for the annexation of British North American territory allowed Canadian politicians to overcome their own sectional differences, while also spurring British parliamentary leaders to urge a stronger central government in British North America, especially after Irish-born civil war veterans launched several unsuccessful raids into Canada. This resulted in the British North America Act of 1867, which united Ontario, Quebec, Nova Scotia , and New Brunswick. Subsequently, in 1870, Canadian Prime Minister John MacDonald successfully convinced the British Government to cede the lands of the Hudson’s Bay Company to Canada, crushing the hopes of U.S. expansionists who hoped to acquire those lands for the United States.