The Proscribed Organisations Appeal Commission (POAC) rejected an application by Home Secretary Jacqui Smith against its November 30 ruling that the People’s Mojahadeen Organisation of Iran (PMOI) should no longer be blacklisted.
Home Office minister Tony McNulty said he was disappointed at the decision and would now seek to take the case to the Court of Appeal.
"The government adopted a cautious approach in relation to the de-proscription of the People’s Mojahadeen Organisation of Iran," he said in a statement.
"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.
"I firmly believe that we should be entitled to take this view."
McNulty said those on the proscribed list were reviewed regularly but the department would look again at its processes to ensure such groups are treated fairly, proportionately and in accordance with the law.
The original case was taken to the POAC by a cross-party group of 35 British lawmakers, including a former home secretary and solicitor general plus senior ranking Scottish and European judges.
The PMOI was the armed wing of the France-based National Council of Resistance of Iran but renounced violence in June 2001.
Chairman of the British Parliamentary Committee for Iran Freedom, Robin Corbett, said Smith "should now admit to the mistake" and implement the POAC’s judgment.
Maryam Rajavi, president-elect of the National Council of Resistance of Iran, said in a statement the tribunal’s ruling was "another affirmation that the terrorist label against the PMOI was ‘perverse’".