In an increasingly bitter clash between the two Houses, the Lords voted by 261 to 198 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."
He added: "This is also the height of hypocrisy in that the system we are proposing is the system the last Tory government introduced for Northern Ireland."
Government sources indicated that the Home Secretary, Jack Straw, viewed the situation as "the last chance for the Lords to see sense".
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 before 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 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, a Home Office minister, warned peers that another government defeat would be a "wholly improper abuse of their power".
In an impassioned 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?"
Criticising the Labour rebels Lord Shore of Stepney and Lord Stoddart of Swindon, who have both voted three times against the Government on the issue, Lord Callaghan said he admired their enthusiasm but he challenged the right of peers to thwart the Government.
"What gives them this right to say, unelected as they are, accountable to no one, that they have the right to say four times in a row, 'We insist that you, the Government, and the Members of the Commons, shall lose their Bill.' What right have they? None at all."
But Lord MacKay of Ardbrecknish urged the Government to accept the open list system proposed in his amendment. He said ministers should recognise they had "very unhappy troops" in their party over the issue.
He insisted: "This Bill does not necessarily need to be lost.The Commons can come back, hopefully with a substantial compromise which might persuade us to accept it - and not these meaningless crumbs of comfort which they hope will buy us off."
Lord McNally, the Liberal Democrat spokesman, called the Opposition tactics a "constitutional outrage".
However, the Bishop of Hereford, the Rt Rev John Keith Oliver, said: "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."
Later, the Tory party leader, William Hague, said the defeat was "a victory for common sense and democracy". He added: "The House of Lords are right to reject a voting system that will deny the voter the choice of candidate in the European elections.
"That is undemocratic, it is not the British way. It is high time the Government started to listen to people on this issue."
The shadow home secretary, Sir Norman Fowler, said: "The House of Lords has been entirely right on this issue. The debate in Parliament has gone conclusively against the Government.
"The Government's closed list system transfers power from the electorate to the party organisations. It is a system of voting which is fundamentally flawed."Reuse content