A three-judge panel of the US federal appeals court in Washington said in its opinion that the State Department "failed to accord the PMOI the due process protections" required by law and called for the status to be reviewed.
The group, which asked for a review of its classification in 2008, was turned down by then-secretary of state Condoleezza Rice in the final days of her tenure.
The court said Rice denied the group even an opportunity to rebut claims it supported terrorist activities, and thereby violated "procedural safeguards required by our precedent."
Maryam Radjavi, head of the Iranian resistance group, said the decision "demonstrates that the terrorist label against the PMOI, and the insistence to continue it, has been merely a political decision in the framework of appeasing the bloodthirsty mullahs and based on the illusion of changing the behavior of the medieval regime ruling Iran."
The group in 2009 was taken off the list of terrorist organizations of the European Union.
Founded in 1965 with the goal of overthrowing the shah of Iran, the group fled Iran after the Islamic revolution and continued to oppose the regime.