The source added: “They got wind of this after an incident at Balmoral when he screamed in the night.”
The concerned friend, who worked for the royals at the time, immediately alerted the boy’s parents.
He told them: “This is something that you should have nothing to do with.”
Reports from the time reveal further details of the boy’s ordeal.
One says his parents discovered a handwritten note from him.
It read: “What Buckingham Palace did for me was exploitation of the highest order.”
The boy’s mother said at the time: “My son was happy and normal until he went there.
"Then he changed completely. He refused to talk to us or discuss what he was up to.”
The boy’s father also claimed that young Palace staff were lavished with expensive gifts for “entertaining men”.
He added: “In some cases Palace officials were involved.
“Afterwards, the servants got good references to take up posts abroad with wealthy employers.”
According to the Home Office files, the desperate parents wrote to Geoffrey Dickens for help.
The MP raised the mother’s concerns with the Home Secretary in 1983.
But Mr Dickens received a reply saying Leon Brittan felt it would not be practical to carry out a detailed investigation.
He wrote: “I need hardly assure you that the Royal Household is extremely concerned at these unsubstantiated allegations and it is, of course, their policy to take every step to avoid an occurrence of such as is alleged.
Mr Brittan indicated that her son had worked at Buckingham Palace for a year, adding: “It is extremely difficult to comment on the accuracy of the allegations in the letter.”
But an even more chilling development is contained in the files, lending weight to the claims that a paedophile VIP ring was linked to the Palace.
During his time at Buckingham Palace, the 16-year-old was approached by notorious paedophile Sir Peter Hayman and was asked to work for him in Canada, where he was ambassador.
Hayman has been identified as a member of the VIP paedophile ring operating in Westminster and is known to have had royal connections.
He was desperate to have the boy working for him, even writing to his parents to ask them about taking his son on as a footman. Hayman said the boy would need winter clothes.
The parents never found out how Hayman knew their son.
But the source said: “They knew there was something wrong.”
The parents were so concerned by Hayman’s approach that they attempted to stop their son working for him, the family friend explained.
Exaro has established that the boy’s parents intervened to stop him going to Canada to work for Hayman.
Mr Watson, who has led the campaign for a full-scale inquiry into claims of child sex abuse at the heart of the Establishment, said: “In light of what we now know, any allegation of sexual crimes regarding Peter Hayman should be thoroughly investigated.
“He was protected by the Establishment at the time.
“The full extent of how his conduct was covered up has not been explained.”
The parents and their son have declined to comment on the allegations.
But the revelations link Buckingham Palace to a paedophile network of MPs and powerful figures that operated over many years in the UK.