A government award of £700,000 to help fund the Omagh families' civil case against those suspected of the bombing was unlawful, the High Court has ruled.
Michael McKevitt challenged the partial funding of the civil case
The payment was authorised by the Lord Chancellor in a civil action claiming compensation of £14m.
His decision was challenged by Real IRA leader Michael McKevitt, one of the five defendants in the case.
The Real IRA has been blamed for carrying out the attack in 1998, which killed 29 people.
In his ruling, Mr Justice Coghlin said the payment was unlawful because the Lord Chancellor had no legal power to order the Legal Services Commission, formerly the Legal Aid Department, to fund the Omagh relatives.
A lawyer for the Lord Chancellor said he would revoke his order and would look at other ways of legally providing financial assistance and would change the law if necessary.
The court was told lawyers had already incurred costs of over £400,000.
However, Judge Coghlin said that as the money had been spent in good faith he would not order repayment.
McKevitt is currently serving a 20-year sentence in Portlaoise prison for running the Real IRA.
He and four other people in the Republic of Ireland - Seamus Daly, Seamus McKenna, Liam Campbell and Colm Murphy - are being sued by the families of those killed in the atrocity.
McKevitt had a claim for £1m in legal aid to fight the case turned down.