Michael Howard, the Home Secretary, immediately announced that he would take the case to the House of Lords. But if he loses, there he will be forced to reconsider the Egyptian-born brothers' naturalisation applications afresh, first informing them of the areas of objection so that they can make representations against them.
While there was no criticism of Mr Howard personally, the ruling is an embarrassing addition to a string of earlier courtroom defeats for him.
In the two-to-one majority judgment setting aside an earlier High Court decision, Lord Woolf, Master of the Rolls, said the rules of fairness required ministers in such cases to identify the areas causing them difficulty in reaching a decision.
The Fayeds, who have lived in Britain since the Sixties and whose children are all British citizens, had "not had the fairness to which they are entitled and the rule of law must be upheld", Lord Woolf said. It followed that the decisions in February last year to reject their applications for British passports had to be quashed so that they could be "retaken in a manner which is fair".
Posing with the Harrods' Father Christmas in a photocall after the ruling yesterday, Mohammed al-Fayed, chairman of the Knightsbridge store and the elder of the two, said that he had lived "blamelessly" in Britain for 30 years. "This is a victory not just for my brother and me but for natural justice, fairness and openness."
It must be one of the few occasions on which the Establishment has come down so decisively on the side of the expansive Mr Fayed who combines a refined lifestyle in Surrey and abroad with a penchant for "blue" expressions.
Lord Woolf was careful not to imply any criticism of Mr Howard as such in the Home Office's reading of the relevant law, the 1981 British Nationality Act, prior to the case reaching the appeal court. But justice had to be seen to be done "and it has not been done in relation to the Fayeds".
The heart of the matter lies at least as far back as 1985, when the brothers won the fabled battle with Lonrho's Tiny Rowland for the House of Fraser Group, if not their origins in a modest corner of Alexandria long before that. After the pounds 615m takeover, a smiling Mohammed, 63, was pictured behind Harrods' meat counter in butcher's apron and straw boater. The Rowland campaign grew ever more bitter, culminating in a damaging Department of Trade and Industry report, eventually published in 1990.
By 1994, an angry Mr Fayed, his citizenship application apparently stalled, went public over "cash for questions" and his former relationship with a Westminster lobbyist, Ian Greer, recruited to tackle the barrage of attacks from the Lonrho camp. One Tory minister, Tim Smith, promptly resigned; another, Neil Hamilton, was forced from office a week later and John Major's administration was awash with allegations of "sleaze". In another broadside against the Government, the elder Mr Fayed sparked the controversy over a stay at the brothers' Paris Ritz hotel by the former Chief Secretary to the Treasury, Jonathan Aitken.
As the brothers' counsel, Michael Beloff QC, put it, their applications had been played out against a background of speculation that the eventual refusals, in letters described by the court as "terse in the extreme", were motivated by "legally improper, purely political grounds".
But while Mohammed al-Fayed has clearly done himself no favours, he will not lightly relinquish his quest for citizenship.
There are practical reasons for the importance put by the brothers on gaining British passports in addition to their long-standing permission to reside here permanently - such as freedom from immigration control, citizenship of the European Union and the right to vote and stand in parliamentary elections. But it is the intangible and symbolic significance that really matters - in particular, the damning effect of having citizenship refused, apparently on grounds that they were not of "good character" since it was not in dispute that they complied with all the formal requirements.
From the Fayeds' point of view, it was like being damned all over again on an identical charge.
After two unsuccessful attempts by Tiny Rowland to get a Department of Trade and Industry inquiry into the House of Fraser takeover, publication of the report that was finally commissioned by the then Secretary of State, Paul Channon, and completed in 1988, was blocked on the ground that a fraud investigation might follow. Mr Rowland took matters into his own hands by securing a copy of the report and publishing chunks of it in March 1989 in an unprecedented mid-week edition of the then Lonrho-owned Observer. When the scathing report was finally published a year later, the brothers, were described as the sons of a teacher of "humble origins" and branded as liars, about their family background, their early business life and their wealth. But to a chorus of parliamentary objections, the trade secretary, by now Nicholas Ridley, said it would not be in the public interest to disqualify them as directors because there were no public shareholders, and the brothers insisted the fact that no action was to be taken exploded the inspectors' "extreme" conclusions.
The brothers contribute millions to the Exchequer either personally or through corporation tax, and are generous to charities, not to mention a pounds 250,000 donation to the Tory party. But none of that, it seems, was going to count. By mid- to late 1994 alarm bells about the citizenship applications, lodged in January 1993 by Ali and February 1994 by Mohammed, began to ring in the Fayed camp. In a bitter blow, their attempt to get the DTI report censured by the European Court of Human Rights failed.
But by October 1994, Mohammed had ensured that the main preoccupation of government was news management. Amid the avalanche of reports in the days following the "cash-for-questions" bombshell, Mr Howard felt obliged to issue an unprecedented written statement admitting he had been consulted over the citizenship applications in April, and had requested the then Home Office minister Charles Wardle, to make "further inquiries". Officials had by then advised against the granting of passports. Nicholas Baker, the minister replacing Mr Wardle in a reshuffle, is understood to have then sought references from the Bank of England.
There was further embarrassment for John Major, who had astounded MPs by announcing he was complaining to the Crown Prosecution Service that Mohammed had sought criminally to pressurise the Government by sending an "intermediary" - Brian Hitchen, then editor of the Sunday Express - to express his anger over the DTI report and the citizenship applications, and raise allegations against four government ministers. The CPS duly announced there was no case to answer but there were fresh predictions that the applications were doomed.
In yet another twist, Mohammed's chief spokesman, Michael Cole, yesterday revived a connection between Mr Howard and his second cousin Harry Landy, who was a director of Lonrho and had sponsored Mr Howard's father when he came to Britain as a refugee from Romania. When allegations involving the link were first raised in October 1994, Mr Howard dismissed them as "utterly ludicrous" and the "stuff of pure fantasy" - and took out an injunction against the Financial Times for good measure.Reuse content