In a podcast interview with Kevin Curley, chief executive of local infrastructure umbrella body Navca, the MP for Sheffield Brightside said grant funding was critical for the core activity of the sector.
He said competitive tendering was not always the best option despite being widespread throughout western Europe. "Through commissioning and contracting, we're creating a market that doesn't really exist," he said.
A policy paper on the sector, which was originally commissioned by Gordon Brown a year ago to make up part of the party manifesto for what was then believed to be an imminent election, will be published before Christmas, said Blunkett.
"It will be a document for testing out and consultation, to get debate going," he said. "We want to show what people are doing to be part of civil society, the glue that binds society and makes Britain a decent place to live."
The paper might be called Mutual Action, Common Purpose: Empowering the Third Sector, he said.
Asked what he expected from the sector in the current financial climate, he said its work would be more important then ever because in times of insecurity people must "be alongside each other".
"I'm a great advocate of looking back to the 19th century, when a tenth of the population belonged to mutual societies of one sort or another; when people had no choice but to work together in either trade unions or communities," he said.
He said the sector did not have a clear idea of which areas of work were suitable for competition.
"If an organisation of any kind – mutual, private or whatever – says ‘we can do this better', the question must be ‘can you do it with us, rather than instead of us?'" he said.
The podcast can be heard here.