The vote plunged Treasury tax and spending plans into confusion, cast doubt over Mr Major's capacity to regain a grip over his own parliamentary party and means that the Cabinet will have to decide in the next 48 hours how to make up the pounds 900m shortfall left after Kenneth Clarke, the Chancellor, announced the cancellation of the second-stage increase in VAT.
There was strong speculation in Westminster early today that the Chancellor, who is due to hold his regular meeting with Eddie George, the Governor of the Bank of England, this morning, may be forced to sanction a swift rise in interest rates to steady market reaction to the defeat.
Gordon Brown, the shadow Chancellor, said immediately that the vote was not only against Budget measures but against a government that was now ''tired, discredited and out of touch''. In a dramatic late-night Commons statement Mr Clarke, flanked by the Prime Minister, announced that he would return to the House tomorrow with a new ''package of spending and taxation measures designed to keep borrowing on course and retain confidence in the strong recovery of this country''.
The Chancellor made his statement after failing to persuade enough Tory rebels to back down and support the Government's decision - first approved by the Commons two years ago - to increase the tax to 17.5 per cent from next April. Tony Blair, the Labour leader, said the Tories had ''lost control of events'' and were no longer fit to govern.
The revolt gave the Opposition its most important Commons victory since 1979 after the Opposition amendment reopening the issue of the second-stage VAT increase was carried by 319 to 311. The defeat was made all the more painful by the fact that Mr Clarke had failed to buy off the rebellion with a last-minute pounds 120m package for the elderly and for home insulation.
The rebels ignored an intensive lobbying effort which continued up to and including the final minutes of the vote and a noisily received appeal by the Chancellor in his winding-up speech not to jeopardise the Government's carefully laid strategy for economic recovery by voting with the Opposition.
Seven rebels voted against the Government and for a Labour amendment designed to kill off the increase - David Sumberg, Paul Marland, Nicholas Winterton, Richard Shepherd, Tony Marlow, Ann Winterton, and Michael Carttiss. Tory abstainers included Sir Teddy Taylor, John Wilkinson, Teresa Gorman, Phil Gallie, and Sir Rhodes Boyson.
The backbench defiance was underlined by the fact that of the eight rebels who lost the whip last week by opposing the European Finance Bill, only one, Nick Budgen, supported the Government - immediately challenging ministerial assumptions that they would now work their passage back to full membership of the parliamentary party by showing their loyalty.
Last night's result is not only the most important Commons victory for Labour in more than a decade but also inevitably throws into doubt the Government's strategy since 1979 of switching the tax burden from income tax to indirect taxes on consumption. The rebels' satisfaction at the outcome of last night's vote was summed up by Sir Rhodes, who said: ''I have never believed in VAT on necessities. It was never intended to go on necessities.''
Right-wing ministers are expected to press for the shortfall to be made up by even deeper spending cuts than the pounds 6.9bn in Mr Clarke's Budget, while others will want taxes to be further increased instead. One possibility canvassed by MPs in a series of conversations with ministers earlier in the day was to increase all existing VAT levels from 17.5 to 18 per cent.
In the Commons, Mr Clarke had appealed in vain to the rebel Tory backbenchers by declaring: ''At this stage it would be quite reckless for this House, having been taken so far on the road to lasting recovery, to suddenly decide that it cannot stay the course.''
As the Prime Minister flew back from the European security conference in Budapest to join Tory MPs voting against Labour, Mr Clarke produced his pounds 120m concession at a tense meeting with a handful of rebels only two hours before last night's critical vote.
The group of backbenchers, led by the veteran pensioners' campaigner Sir Andrew Bowden, MP for Brighton Kemptown, secured another pounds 100m in special aid for the elderly on top of the existing pounds 900m compensation package to help with their fuel bills. In the end, however, only sir Andrew, Tim Rathbone, and Harry Greenaway were successfully dissuaded by the package.
Whips could be clearly seen cajoling rebels and potential rebels on the government benches after the critical division had begun in a final effort to prevent them wiping a gross pounds 1.5bn off the planned revenue total for next year.
Age Concern said last night that the vote would lift fears about heating costs for millions of pensioners. Sally Greengross, director general of the charity, said: ''Millions of elderly people will wake up feeling very relieved.''