In an increasingly bitter clash between the two Houses, the Lords voted by 261 to 198 - a majority of 63 - for an "open list" system which would allow electors to vote for named candidates.
The Government has already overturned three previous defeats, insisting on the "closed list" system under which electors can vote only for the party of their choice and not individual candidates.
Tony Blair condemned the defeat as an "affront to democracy", saying: "The Tories claim to be representing the interests of democracy yet can simply wheel out hereditary peers, elected by nobody, to overturn the democratically elected government. Every time they do so they make the case for the reform of the Lords."
The European Parliamentary Elections Bill will go back to the Commons for the fifth time today and ministers will have to decide whether they will stand firm and continue the "parliamentary ping-pong" over the issue.
If no compromise is found until Parliament prorogues tomorrow, ministers are likely to rush through a new Bill during the new session of Parliament which opens later this month.
But Labour backbenchers both in the Commons and the Lords have joined peers in their criticism that closed lists are undemocratic because they would give too much power to the centralised party machine.
Summing up after a tense debate, Lord Williams of Mostyn, the Home Office Minister, warned peers that another government defeat would be a "wholly improper abuse of their power".
In an impassionate plea, Lord Callaghan of Cardiff, the former Labour prime minister, urged the Tories to "stop playing games and call off the troops". He spoke of a "self-confessed hooligan tendency" in the Conservative Party, adding: "Are you really doing a service for the chorus of democracy? What gives you the right, being unelected and unaccountable to no one, to insist that the Government lose their Bill."
Lord McNally, the Liberal Democrat spokesman, called the Opposition tactics a "constitutional outrage".
However, the Bishop of Hereford, the Rt Rev John Keith Oliver, pronounced his dismay over the "closed lists" system, saying: "I agree that no system is perfect, but this system is the least perfect and the right thing for me to do by the democratic principle which has prevailed in this country for a very long time is to vote for open lists."
The Tory party leader, William Hague, said the defeat was "a victory for common sense and democracy".Reuse content