The US authorities do not have the power to detain an American citizen seized on US soil as an "enemy combatant", a court has ruled.
Padilla has been in US military custody since last June
The federal appeals court said "dirty bomb" suspect Jose Padilla - being held by presidential decree - should be released from military custody.
But the judges added that the US Government was free to transfer him to civilian jurisdiction.
The ruling is being seen as a setback for Mr Bush's anti-terror policies.
Mr Padilla is thought to be the only US citizen since World War II to be detained on a presidential order.
"We are as keenly aware as anyone of the threat al-Qaeda poses to our country and of the responsibilities the president and law enforcement officials bear for protecting the nation," the US Second Circuit Court of Appeals said in its ruling.
"But presidential authority does not exist in a vacuum."
So-called "dirty bombs" contain radioactive material such as plutonium
Mr Padilla must now be released from military custody within 30 days. Without this ruling he could have faced a military tribunal.
The "enemy combatant" classification has been used to detain terror suspects, who may be held indefinitely without charge or trial and without access to lawyers.
More than 600 people, mostly alleged members of the al-Qaeda network or Afghanistan's former Taleban regime, are currently being detained in Guantanamo Bay under the classification.
BBC correspondent Justin Webb in Washington says the case has no immediate bearing on the fate of the Guantanamo prisoners, but for US citizens it is an important development.
It may suggest that the US Government does not have the right, under US law, to arrest them and hold them without charge - however grave the accusations against them might be.
White House spokesman Scott McClellan called the ruling "troubling and flawed" and said the US Justice Department would seek a stay on the court's ruling and request further judicial review.
"This is a person actively engaged in an effort to do harm to the American people," he said.
Prosecutors accuse Mr Padilla, a former gang member who reportedly converted to Islam in prison, of conspiring with the al-Qaeda network to blow up a so-called dirty bomb.
This is a device made of radioactive material and attached to conventional explosives which could potentially cause mass casualties, both from the blast and from exposure to radiation.
Since Mr Padilla's designation in June 2002 he has been held in solitary confinement at a naval facility in Charleston, South Carolina.
He was arrested one month earlier at Chicago airport after returning from Pakistan on what the US authorities say was a reconnaissance mission.
US federal prosecutors have argued that Mr Padilla should not have access to legal counsel because he poses a threat to national security.
But his defence countered that his constitutional rights were being violated.