The government has suffered a significant defeat in the Lords over its plans for a so-called "bedroom tax" on people living in council accommodation deemed to be too large.
Ministers want to tackle under-occupancy and reduce the housing benefit bill by stopping residents of council or housing association property from having an extra bedroom.
Under the current rules, one spare bedroom is allowed.
Families who don't move somewhere smaller will have their housing benefit cut by an average of £14 a week.
As peers began the second day of report stage debate on the Welfare Reform Bill on 14 December 2011, crossbench peer Lord Best introduced an amendment to limit the penalties to those households with two or more spare bedrooms and those with one extra room who have been offered suitable alternative accommodation.
Lord Best argued the proposed test of under-occupancy was too stringent and did not take into account personal circumstances.
"Under the fierce new test, the family would be counted as under-occupying if, for example, two teenage girls were not sharing the same room," he claimed.
"670,000 households receiving housing benefit will be caught in this trap," he argued.
Labour peer Baroness Hollis of Heigham said "this is not about finding homes for the 3% of families who are overcrowded
we could solve that tomorrow if we built the bungalows or the suitable flats for pensioners who are queuing up for them".
She accused the government of seeking to cut the housing benefit bill "by telling a third of our tenants in social housing, mostly disabled, that they have to find somewhere smaller to live".
Welfare Reform Minister Lord Freud said the measure was "essential, to reduce housing benefit expenditure which, without reform, would reach £25bn in cash terms by 2014-15.
"In these difficult economic times we cannot avoid having to make these choices
these decisions have not been taken lightly," he added.
Lord Freud announced a £30mn annual fund to help certain groups stay in their homes regardless of the size, such as disabled people and foster carers.
While welcoming the concession, peers voted to support Lord Best's amendment by 258 votes to 190, defeating the government by 68 votes.