More than 20 Labour MPs rebelled in a serious blow to Jeremy Corbyn's authority following an "embarrassing" U-turn over the party's economic policy.
Shadow chancellor John McDonnell urged Labour MPs to oppose the Government's updated Charter of Budget Responsibility, having previously said they would support the "meaningless" document.
Thirty-seven Labour MPs failed to vote, although 16 MPs are understood to have had permission to stay away from the lobbies, leaving 21 rebels including former shadow cabinet ministers Chris Leslie and Tristram Hunt.
Blairite former Cabinet minister Ben Bradshaw, who described Mr McDonnell's stance as a "total f*****g shambles" following a stormy meeting of the Parliamentary Labour Party on Monday, also abstained in the vote as did Liz Kendall, who ran against Mr Corbyn for the leadership.
Mr McDonnell, who was barracked by Tory MPs during his Commons speech, repeatedly acknowledged the U-turn was "embarrassing" as he set out the party's new position on the public finances.
He told the Commons that he had not changed his mind on the "need to tackle the deficit" but on the "parliamentary tactics".
George Osborne's new charter commits the Government to running an overall budget surplus by 2019 and every year from then on in "normal" times. It was passed by 320 to 258, a majority of 62.
Explaining his decision in the House, Mr McDonnell said: "When the circumstances and judgments change it is best to admit to it and change as well."
Mr McDonnell also questioned the true purpose of the fiscal charter.
"It is increasingly clear that the charter and the fiscal mandate are not economic instruments, they are political weapons," he said.
The debate is not about economics but about the "politics of dismantling the welfare state, the closing down of the role of the state and the redistribution of wealth from the majority to the minority".
"Austerity is not an economic necessity it is a political choice," he said.
Labour's deficit reduction programme would not be wrought "on the backs of middle and lower earners", would be fairer than Mr Osborne's approach, and would be on a looser timescale, Mr McDonnell said.
The shadow chancellor also announced a review of the remit of the Bank of England's Monetary Policy Committee (MPC), which is in charge of setting interest rates and meeting the inflation target, will be led by former MPC member Professor David Blanchflower as part of Labour's "radical project".
The 21 Labour MPs who defied the whips were Rushanara Ali (Bethnal Green & Bow), Ian Austin (Dudley North), Adrian Bailey (West Bromwich West), Ben Bradshaw (Exeter), Ann Coffey (Stockport), Simon Danczuk (Rochdale), Chris Evans (Islwyn), Frank Field (Birkenhead), Mike Gapes (Ilford South), Dame Margaret Hodge (Barking), Tristram Hunt (Stoke-on-Trent Central), Graham Jones (Hyndburn), Helen Jones (Warrington North), Liz Kendall (Leicester West), Chris Leslie (Nottingham East), Fiona Mactaggart (Slough), Shabana Mahmood (Birmingham Ladywood), Jamie Reed (Copeland), Angela Smith (Penistone & Stocksbridge), Graham Stringer (Blackley & Broughton) and Gisela Stuart (Birmingham Edgbaston).