The claimed exploit was posted to a mailing list minutes ago.
Free-X had been trying to negotiate with Microsoft, and was requesting the release of a "signed" Linux boot loader, which would allow Xbox owners to run the open source operating system without any hardware modifications or the exploitation of the console. Microsoft would not negotiate, group members told ZDNet Australia.
Group representatives reject claims they are encouraging piracy and accuse the software company of failing to protect its game developers' intellectual property. A signed boot loader won't allow the console to run pirated games, whereas the exploit they have developed will. Free-X say piracy is not something they wish to encourage.
"If Microsoft had agreed to sign Linux then it would have been possible... to prevent the illegal use of pirated software," the statement said. "It is a shame that Microsoft appears to not share our concerns about protecting the intellectual rights of those who develop software for their console".
Far from seeing the group's actions as an anti-piracy move, Microsoft has threatened to come down on them like the proverbial tonne of bricks.
"We do need to inform yourself and this... contact that Microsoft Xbox takes pirating of videogames very seriously," a Microsoft spokeswoman told ZDNet Australia by e-mail. "The protection of our intellectual properties and copyrights, and those of our partners, is a top priority and therefore we reserve the right to pursue and take action against anyone facilitating piracy of videogames".
When the group initially approached ZDNet Australia several weeks ago it did not disclose its most serious claimed exploit, instead saying that all of the hacks they had developed required the soldering of a few pins on the Xbox motherboard. Free-X now says the console can be modified through software only, and Microsoft has run out of time.
"Today is a very sad day for Microsoft," a statement read. "One month ago, we began an attempt to make contact with Microsoft, we did this because the first software only mod-chip solution was developed and proved working. This solution meant that there was no need to open the XBox anymore".
The only way Microsoft can protect its console from the exploit is to release new firmware or revised Xbox "Dashboard" software, they say.
The Free-X members say they are frustrated by the public's perception that it is trying to blackmail the software giant into releasing the Linux boot loader.
"Since our attempts to contact Microsoft have become public knowledge our team has been accused of attempting to extort or blackmail Microsoft, this is not true as we have made every attempt possible to make contact with Microsoft," a group member said in the statement.
Free-X offered Microsoft a summary of all the exploits it developed, help with securing the console from other attacks, source codes, full confidentiality and further research into Xbox exploits.
"Our team was more than willing to cooperate with Microsoft and would have most likely accepted most of the terms of agreement coming from our discussions," the statement said.
The Microsoft spokeswoman says the group's claims are being "evaluated".
If the claim by Free-X turn out to be true they may be eligible for the US$100,000 prize on offer by Lindows chief executive Michael Robertson for the first group to run Linux on the console without hardware modifications.