The kingdom's influence toward radicalism across the world, is "unhealthy and we need to do something about it," Sir William Patey said.
"The Saudis [have] not quite appreciated the impact their funding of a certain brand of Islam is having in the countries in which they do it – it is not just Britain and Europe.
"That is a dialogue we need to have. They are not funding terrorism. They are funding something else, which may down the road lead to individuals being radicalised and becoming fodder for terrorism."
Patey said the Saudis "find it very easy to back off the idea that they are funding terrorism because they are not.
"What the World Association [sic] of Muslim Youth and the Muslim World League are doing is funding mosques and promoting an ideology – the Salifist Wahhabist ideology."
The former ambassador, who also previously as the head of Britain's Foreign Office Middle East desk, urged for a clearer definition of funding terrorism and "a grown-up dialogue with the Gulf about what we think," noting further "individual Gulf citizens that defied their governments to fund terrorism".
Buried terror report
The comments come a day after the UK published a brief summary of a controversial government report looking into the funding of terrorism.
Citing national security and sensitive information, Home Secretary Amber Rudd published a 430-word summary of the undisclosed report, which is thought to be critical of Saudi Arabia.
The decision to withhold the report sparked criticism by the opposition, including Shadow Home Secretary Diane Abbott who said the public "has a right to know if any governments, foreign or domestic organisations or individuals are funding extremism in this country".
"Of course, security intelligence should not be compromised but this is easily achieved by redaction and other means. The government would never have commissioned this report if it considered this problem insurmountable.
"Instead, there is a strong suspicion this report is being suppressed to protect this government's trade and diplomatic priorities, including in relation to Saudi Arabia. The only way to allay those suspicions is to publish the report in full."
The published statement did not offer information into which governments were involved in funding terrorism.