SAN FRANCISCO — Hercules, Calif., said it has tentatively settled a $4 million lawsuit brought by Ambac Assurance Corp. over a default by the city’s redevelopment agency.

The settlement with Ambac, which insures the defaulted bonds, will keep the city from having to start the Chapter 9 bankruptcy process, city manager Steve Duran said in a statement Friday.

“This outcome will keep the city from having to consider pre-bankruptcy mediation and a potential Chapter 9 bankruptcy protection filing,” Duran said.

The details of the settlement have yet to be released. On Tuesday, the agreement will be presented to the court for approval.

Hercules, which has a population of around 26,000, is situated on the northeast shore of San Francisco Bay.

Ambac alleged in the lawsuit, filed last month in Contra Costa County Superior Court, that the Hercules Redevelopment Agency illegally transferred $4.1 million of tax money collected in December to the city instead of using it to pay bondholders. The suit demanded the city move the money to the bond trustee to pay investors.

The suit came after Ambac found out the agency, which shut down Feb. 1 along with every other RDA in California, would default on a $2.4 million debt-service payment at the start of February, using the insurer’s surety reserve instead of tax revenue. Duran said Hercules’ pooled cash funds had been subsidizing the agency’s debt service for years.

Ambac has issued surety bonds and insured $56.2 million of tax-allocation bonds issued by the RDA in 2005 and $60.5 million of tax-allocation bonds issued in 2007. The insurer did not respond to a request for comment.

Standard & Poor’s last month downgraded to BB from A-minus the ratings on revenue bonds issued by the Hercules Public Financing Authority for the city, a five-notch drop, and placed them on watch for potential further downgrades.

S&P last month also dropped the underlying rating on the RDA’s tax-allocation bonds further to CC from CCC.

The RDA and the Public Financing Authority have more than $162 million of outstanding debt, which does not include debt associated with assessment districts.

Hercules’ financial problems have been complicated by recent California legislation that forced RDAs to shut down at the start of February. Obligations between cities and their RDAs, such as loans or transfers, made since the beginning of last year could be voided because of the legislation.

State finance officials have said contracts between RDAs and third parties, such as bondholders, should be protected.

The Ambac suit is the latest in a string of financial troubles for Hercules. In August, state Controller John Chiang ordered an investigation into the city, saying his office found major problems with its finances. The investigation is still ongoing.

Earlier in 2011, the Contra Costa County grand jury said in a report that Hercules  used bond funding to make up a $6.6 million deficit. In 2010, the same grand jury described the appearance of impropriety and-or lack of transparency in the city’s housing and business loan program.

In June, residents voted to recall Mayor Joanne Ward and Councilman Donald Kuehne.

In an effort to stabilize its finances, the City Council last week voted to put a measure on the June ballot that would raise the sales tax rate to 8.75% from 8.25%. The city said it could raise up to $400,000 annually. The money would be enough to prevent further layoffs, Duran said.

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