As my afternoon ferry from Phuket approaches Thailand's Phi Phi Island, Tonsai Bay's pier hums with life. Hotel touts greet the arrivals: small groups of Western backpackers, and older tourists pulling heavier trolley-style suitcases. An old woman peddles guava, pineapple and watermelon. Labourers unload beer and bottled water from the colourfully emblazoned Hippies Phi Phi Cargo Boat. Scuba diving shops' brightly painted boats bob gently in the mountain-rimmed bay's placid waters. The contrast with the grim desolation I saw here in the days just after the December 26 tsunami moves me nearly to tears.

Of all Thailand's battered holiday destinations, tiny Phi Phi Island, the backpackers' and scuba divers' Mecca, was one of the hardest hit. Its spectacular double-crescent beach was pummelled from two directions; people fleeing the tsunami waves that pounded Tonsai Bay were then swallowed by the wall of water from Lo Dalam Bay. More than 700 people are known to have perished on the island; 500 more are still recorded missing.

I first visited Phi Phi two weeks after the calamity, when most traumatised survivors - both foreign tourists and local residents - had fled. Then our speedboat moved through waters still choked with debris, and pulled up next to a police boat, carrying officers - wearing protective face masks over their mouths and noses - resting from the grim task of retrieving bodies.

On the otherwise silent and deserted pier, I met two Czechs, who had travelled from Prague to search for a missing friend. The sight of the destruction must have dashed their hopes. On the nearby beach, I gaped at small refrigerators, industrial kitchen equipment, televisions and chairs that the sea had tossed about like children's toys, and the vast, brown empty space where nearly 200 bungalows, all washed into the sea, once stood.

Amid the ruins, I noticed batik dresses, hanging from a metal bar over the entry to what was once a souvenir shop. The apparently untouched garments fluttered eerily in the breeze, as if still waiting for buyers - buyers, I was convinced, who would never come. Like a modern-day Pompeii, Phi Phi was a place where life had been brutally interrupted. It was impossible to imagine it ever resuming as before.

But, astonishingly, Phi Phi's tenacious entrepreneurs are gradually resurrecting their businesses, defying the horror of the recent past. Just off the pier - under a new sign declaring "We Are Ready to Receive You", nine hotels, partially or completely open, have tacked their glossy brochures.

Along the main thoroughfare, where hammer blows still echo, I see vendors sitting behind small tables laden with seashell necklaces, blown glass trinkets, and pirated CDs of Hollywood films. Young Muslim women behind griddles make hot traditional pancakes filled with sweetened condensed milk. A man sells brightly coloured T-shirts that declare with a black humour "Still Alive" on the front. On the back, the shirts read: "Phi Phi Island: 2001 Bomb Scare. 2002 Sars. 2003 Bird Flu. 2004 Tsunami. What next?"

Ing Chanakan, 38, is typical of the long-time Phi Phi residents trickling back to the island, braving their memories of the tsunami and its still visible destruction. Ms Ing first came to Phi Phi from Krabi, on the Thai mainland, 17 years ago to set up a small tailor's shop. She later moved into the souvenir business and says her shop, Oasis, had Bt700,000 (£9,350) in monthly sales with a 30 per cent profit margin. When the tsunami hit, she lost Bt2m worth of stock - and was nearly swept away herself. The next day, she fled to Krabi. "I planned never to come back because I saw so many people die and I lost many old friends," she says. "But I had to come back: Phi Phi is home."

In rehabilitating her shop, which is one of the few remaining structures in its area, Ms Ing received help from Dublin house-builder John McGee, 59, and his engineer son Sean, 29. The men were spending six weeks as part of a grassroots effort by foreign tourists, working side by side with local Thais, to reconstruct Phi Phi. Though Mr McGee had never visited the island before, he was inspired by a Dublin TV station's plea for help. With him, he brought his own cement mixer, bought on the mainland. "The cause was good and we had skills and thought we might be able to help," Mr McGee says.

With their wheelbarrows, water pumps, hammers, paintbrushes and other tools, the foreign volunteers and Thais working together are an awe-inspiring, humbling testament to human resilience and capacity to hope. But in their reconstruction effort, Phi Phi islanders are battling not only the passivity of despair but another powerful force: Thailand's government.

The government and its influential business supporters are aiming to remake the naturally stunning, haphazardly developed, now battered, island as a safe, eco-friendly, and expensive, destination for the well heeled. It is a vision with little room for most of those who profited from Phi Phi's rather down-market pre-tsunami tourist trade. "We dream: why not try to create Phi Phi Island as a unique five-star tourist spot for Thailand and the world," says Plodprasop Surasawadi, chief of the Designated Area for Sustainable Tourism Administration. "We can stop this ecology from deteriorating."

Over the past decade, Phi Phi had indeed suffered the depredations of uncontrolled development, much of which was of questionable legality. Though the island archipelago was declared a marine national park around 15 years ago, villagers - and some mainlanders from powerful political families - obtained coveted landownership documents for the narrow sandbar between the two gorgeous bays, which excluded the spectacular area from park protection. In keeping with Thailand's freewheeling capitalist tradition, the landowners, or their tenants, built without restraint: bungalows, multistoreyed hotels, shops, restaurants and bars.

From the more than 2,000 hotel rooms and local houses, untreated sewage flowed into the sea; while rotting rubbish, piled in the streets or buried in shallow holes, scented the air. The tiny area was so jam-packed that the near 300,000 annual visitors and locals were virtually shoulder-to-shoulder on the narrow roads. On December 26, it was a death trap.

In the aftermath of the tragedy, environmentalists and thoughtful Phi Phi businessmen called for Bangkok to seize the chance to roll back the

unfettered development of the past and restore and protect the island's natural beauty. Interior ministry urban planners drew up a new zoning plan that would impose order and more tightly regulate building, while enhancing public safety with wider roads and seafront setbacks. Local landlords and business owners endorsed the scheme.

But then, in late January, Plodprasop's office unveiled a more radical suggestion: all remaining hotels, shops, restaurants and buildings would be cleared from the double-crescent beach and the government would buy the approximately 275 rai (120 acres) area from its 30 owners. The proposed

compensation for the sellers was shares in a new public company that would be established to build and operate high-end resorts in the hills overlooking the back-to-back bays.

Plodprasop, who reports directly to Thai prime minister Thaksin Shinawatra, says the main purpose of clearing the sandbar would be to guarantee public safety in case any future

tsunami hits the vulnerable spot. Bangkok's proposed new beach construction safety code - which may require setbacks up to 50 metres from the shoreline - would anyway restrict reconstruction on the landspit, scarcely more than 100 metres wide at its narrowest. Plodprasop says "It is almost impossible that from now on we can allow them to build any building in such a sensitive area any more."

Instead, up to 2,000 upmarket units could be built on the hillsides - leased long-term from the state - to accommodate wealthy visitors, with Bangkok providing necessary infrastructure to support construction. The beach, a coconut plantation prior to the building boom, would be left as open space for public recreation and enjoyment.

But Phi Phi's old order strongly objects to the tentative plans, still opaque and with many unresolved details. Many suspect that powerful businesses allied with Mr Thaksin's government, and wealthy foreigners, will take control of the island, while rough-edged locals will be marginalised. "Local people like us cannot come near a five-star hotel," says Manop Konkaoreap, 57, the weathered, barefoot village chief, who owns seven valuable rai (2.8 acres) of the land in question. "How many years will it take, and what will we do all that time?" he says.

Shopkeepers, meanwhile, are betting that richer foreigners, unlike young backpackers, will have little interest in their staple products of T-shirts and trinkets and mango milkshakes, despite official suggestions that prices could be raised for the new clientele.

The government says most opponents of its big idea are small business owners who don't have their own property. Yet Witchuda Janthro, 60, who owns hotels with nearly 200 rooms and 120 stylish shop-houses, says she doesn't like it either. The Hat Ya-based property developer scoffs at the idea that building on the steep hills will be safer than on the flat sandbar. "The hill is not strong enough to hold that," she says. "In the rainy season, it can rain for seven days in a row. Lots of people warn about the landslides, but they say they have high-tech equipment to guard against landslides."

She says locals are united in their resistance to the idea. "All the people who do business here are holding hands tightly, and we are not going to move up to the hill," she says.

The reality is that even as a ramshackle yet romanticised backpacker haunt, Phi Phi was a cash cow, especially for landowners. Until December 26, island property was not available "at any price". Though a few landholders are now trying to sell for around Bt17m per rai - roughly £238,000 for just under ½ an acre - the others believe powerful elites see Phi Phi's current misfortune as a chance to grab their valuable assets.

Up and down Thailand's affected coast, land battles have emerged in the wake of the tsunami. Battered fishing communities have been refused official assistance to rebuild their beachfront villages, after developers claimed ownership of the property. While Bangkok says it is not taking sides, it insists that disputes be resolved before reconstruction can begin, delays that fall far harder on displaced victims in temporary housing.

Plodprasop insists Phi Phi property-owners will not be forced to sell against their will. But locals have been squeezed by administrative measures imposed after the tsunami. For nearly three months, Thai authorities declared the island off limits, because of safety and hygiene concerns.

Local landlords and business owners were technically forbidden from beginning the arduous clean-up task, ordered instead to wait on the mainland, many in temporary shelters, while officials pondered the island's fate. But, as with many other Thai laws, the "keep out" edict was gradually ignored. With the number of returnees growing, the province in late March reversed its designation of Phi Phi as an off-limits "red zone".

Twice daily, teams dive to remove some of the vast quantities of debris from the water, coral reefs and sea floor. On land, western travellers, working under the banner of Hi (Help International) Phi Phi, clear debris, reinforce walls, paint, clean wells and lay new floors in salvageable buildings. Initial funds for tools came from selling items salvaged from the wreckage; today, volunteers lead visitors on daily "tsunami tours" to tout the reconstruction effort and press for further funds.

Yet, even as the rehabilitation and flow of tourists gains momentum, Phi Phi's future remains uncertain. After further studies of the environment and community, the government intends to present a final plan for the island at the end of this month. But, tired of waiting and determined to be up and running by the next tourist season, locals may soon move from restoring existing buildings to constructing new ones without any rules imposed.

Unable to secure bank loans in some cases, locals will build what they can, potentially resulting in the ugly,

haphazard, low-grade development that Bangkok was so eager to avoid. Still, Plodprasop, who describes himself as "an uncompromising man", insists a better Phi Phi will emerge from the ruins. "It will not go back to the old situation," he says. "You will never see the slum in that place any more. If it will happen, I will burn it myself."

Local hoteliers are just as determined to push ahead with their plans. "Phi Phi is a diamond mine for everybody who does business here," says Charnnarong "Charlie" Taecharachkij, 53, a Phi Phi tourism pioneer, whose 200 wood and thatched bungalows were swept away. "That is the reason we fight so hard. Everyone wants a share."

Amy Kazmin is the FT's correspondent in Bangkok