Federal Court Justice Elizabeth Bennett on Friday determined the six-month order, made by Victoria Police Assistant Commissioner Brett Curran on November 30, was invalid under the law.
The declaration listed the Melbourne CBD and neighbouring suburbs as a designated area where police could stop and search people for weapons without a warrant or any suspicion of wrongdoing.
Police could also direct a person wearing a face covering to leave the area if they believed the person was trying to conceal their identity or protect themselves from substances like OC spray.
Justice Bennett found Mr Curran had misunderstood the statutory test he had to apply before making the declaration, so the order was legally invalid.
"There is a realistic possibility that the decision that was made could have been different if the correct standard had been applied," the judge said in her written reasons.
The November 30 declaration was lifted prematurely on January 9, with Mr Curran telling the court he did so to consider aspects of the Charter of Human Rights.
In her findings, Justice Bennett determined Mr Curran had failed to properly consider section 13 of the charter, which protects a person's right to privacy.
That mistake rendered the declaration unlawful, the judge found.
Human Rights Law Centre's legal director Sarah Schwartz described the ruling as a significant win for the protesters.
"It's laid bare significant and systemic failures in Victoria Police's decision-making process, one which has led to extraordinary powers being exercised without proper basis and without consideration of human rights," she told reporters outside court.
"For too long Victoria Police have had unchecked powers to infringe people's fundamental human rights in designated areas ... this case means they can no longer do so."
Tarneen Onus Browne, one of the protesters who led the legal challenge, said the ruling was a victory for Indigenous people joining the Invasion Day rally on Monday.
"This case puts Victoria Police on notice - you cannot trample on the rights of First Peoples," she told reporters.
Justice Bennett only found the November 30 declaration was invalid and unlawful, not designated areas as a whole.
The judge also ruled the power to remove face coverings was constitutionally valid, so long as police carried out the powers in a lawfully declared designated area.
Ms Schwartz said even with those findings, the police would have to be more careful in their considerations.
"It will be significantly harder for Victoria Police to make these sorts of broad declarations," she said.
"That's ultimately consistent with the legislative scheme which is meant to only apply in extraordinary circumstances."
A Victoria Police spokesperson said the force respected the court's decision.
"Our intent has always been to protect the community and remove dangerous weapons from our streets," the statement read.
"Victoria Police will now take the time to consider the court's findings."
There were no plans to declare the Melbourne CBD a designated area on Monday, the spokesperson said.
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