Judges Victoria Sharp, Jonathan Swift and Karen Steyn said "the nature and scale of Palestine Action's activities" did not meet the "level, scale and persistence" that would justify proscription.
The judges said they were "satisfied that the decision to proscribe Palestine Action was disproportionate".
Palestine Action co-founder Huda Ammori said the decision "is a monumental victory both for our fundamental freedoms here in Britain and in the struggle for freedom for the Palestinian people, striking down a decision that will forever be remembered as one of the most extreme attacks on free speech in recent British history".
Home Secretary Shabana Mahmood said she was "disappointed by the court's decision and disagree with the notion that banning this terrorist organisation is disproportionate".
"I intend to fight this judgment in the Court of Appeal," she said on Friday.
In 2025, the UK government declared the pro-Palestinian group a terrorist organisation alongside the likes of al-Qaeda and Hamas, making membership in or support for Palestine Action a crime punishable by up to 14 years in prison.
Since then, more than 2000 people have been arrested for holding signs saying "I support Palestine Action".
Supporters of Palestine Action and civil liberties groups say the arrests for peaceful protest ride roughshod over free speech and the right to protest.
The government banned Palestine Action after activists broke into a Royal Air Force base in June to protest British military support for Israel's war against Hamas in Gaza.
The activists sprayed red paint into the engines of two tanker planes and caused further damage with crowbars.
Palestine Action has carried out direct action protests at military and industrial sites in the UK since it formed in 2020, including breaking into facilities owned by Israeli weapons manufacturer Elbit Systems UK.
Officials say the group's actions have caused millions of pounds in damage that affect national security.
In their ruling, the judges said that while "a very small number of its actions have amounted to terrorist action ... regardless of proscription, the criminal law is available to prosecute those concerned".
