The Government has lost the latest round of a legal battle over its back-to-work schemes.
Three Court of Appeal judges in London have dismissed its challenge against an earlier High Court ruling.
The Government had appealed in a bid to prevent thousands of individuals who had jobseeker payments stopped from clawing back millions of pounds in lost benefits.
Friday's decision is the latest in litigation over back-to-work schemes following a Supreme Court ruling in October 2013.
Five justices at the highest court in the land ruled, in what became known as the Poundland case, that the Government's flagship back-to-work schemes were flawed because sufficient information had not been given to claimants to enable them to make representations before benefits were stopped.
The Government brought in emergency retrospective legislation, the Jobseekers (Back to Work Schemes) Act 2013, to "protect the public purse" and stop the payouts.
It was argued the sanctions had been justified and the claimants would be receiving "undeserved windfall payments".
But a High Court judge, Mrs Justice Lang, declared the 2013 Act "incompatible" with Article 6 of the European Convention on Human Rights, which protects the right to fair hearings.
The Department for Work and Pensions (DWP) decided not to make any payouts pending the Court of Appeal bid to overturn Mrs Justice Lang's decision.
Appeal judges ruled on Friday that when Parliament enacted the 2013 Act in order to retrospectively "validate those sanctions" it was "successful in doing so as a matter of English law".
But Lord Justice Underhill, announcing the ruling of the court, said: "But we have also held - upholding the decision of the High Court - that in the cases of those claimants who had already appealed against their sanctions the Act was incompatible with their rights under the European Convention on Human Rights."
He added: "Under the Human Rights Act that 'declaration of incompatibility' does not mean that the 2013 Act ceases to be effective as regards those claimants; it is up to the Government, subject to any further appeal, to decide what action to take in response."