Ministers have been refused leave to appeal against a decision ordering it to take an Iranian opposition group off a list of banned terror organisations.
The exiled People's Mujahideen is opposed to Iran's government
The Proscribed Organisations Appeal Commission (POAC) turned down the application regarding the People's Mujahideen Organisation of Iran (PMOI).
The government voiced disappointment at the decision and said it would take the case to the Court of Appeal.
Home Office Minister Tony McNulty said the government needed to be "cautious".
"I remain convinced that, where terrorism is concerned, the rights of the law-abiding majority and the overriding need to protect the public, both in the UK and abroad, must lead us to take such a cautious approach," he said.
"I firmly believe that we should be entitled to take this view."
Lord Corbett of Castle Vale, chairman of the British Parliamentary Committee for Iran Freedom, said he was not surprised by the decision.
"POAC found, on the facts, that the home secretary got the law wrong, ignored the evidence, asked the wrong question and so reached a 'perverse' decision," he said.
"The home secretary should now admit to the mistake and implement POAC's judgment, which ordered the removal of Iran's main democratic opposition, the PMOI, from the list of proscribed organisations."
Maryam Rajavi, president-elect of the National Council of Resistance of Iran, said the ruling was "another affirmation that the terrorist label against the PMOI was 'perverse'".
The exiled PMOI used bases in Iraq before the fall of Saddam Hussein to launch attacks on Iran, but says it has renounced violence since 2001.