A panel of nine Law Lords who preside over the highest court in the land at the House of Lords found that the procedure did not amount to a fair trial and contravened the European Convention on Human Rights.
They ordered that the cases should be heard again.
The Government introduced control orders, which impose virtual house arrest, in 2005 after the Law Lords ruled that the previous policy of detaining foreign terror suspects without trial or charge was incompatible with human rights.
Lord Phillips, the senior Law Lord, said that a judgment at the European Court of Human Rights (ECtHR) required the appeals to be allowed.
Lord Hoffman agreed, but added: "I do so with considerable regret, because I think that the decision of the ECtHR was wrong and that it may well destroy the system of control orders, which is a significant part of this country's defences against terrorism."
Home Secretary Alan Johnson called the judgment "extremely disappointing".
He said: "Protecting the public is my top priority and this judgment makes that task harder.
"Nevertheless, the Government will continue to take all steps we can to manage the threat presented by terrorism.
"All control orders will remain in force for the time being and we will continue to seek to uphold them in the courts. In the meantime, we will consider this judgment and our options carefully.
"We introduced control orders to limit the risk posed by suspected terrorists whom we can neither prosecute nor deport.
"The Government relies on sensitive intelligence material to support the imposition of a control order, which the courts have accepted would damage the public interest to disclose in open court.
"We take our obligations to human rights seriously and as such we have put strong measures in place to try to ensure that our reliance on sensitive material does not prejudice the right of individuals subject to control orders to a fair trial."
But human rights groups called on the Government to scrap the control order regime.
Amnesty International said: "This is a welcome victory for justice.
"The Law Lords have rightfully found that the control order regime in which the accused cannot see, challenge or effectively defend themselves against the evidence is unfair and a violation of human rights.
"The Home Secretary should pay close attention to this decision and scrap the control orders regime."
Shami Chakrabarti, director of Liberty, said: "I can think of no better way for the Prime Minister to make a fresh start for his Government than to abandon the cruel and counter-productive punishments without trial instituted by his predecessor.
"This is also a great opportunity for the new Home Secretary to prove his commitment to human rights and fighting terrorism within the rule of law."
Shadow home secretary Chris Grayling said: "This is further evidence of the Government's failure to create a proper regime to control dangerous terror suspects in the UK. They have set up a system which just isn't working properly and is in urgent need of review."
Liberal Democrat home affairs spokesman Chris Huhne said: "Today's unanimous ruling clearly states that control orders are a fundamental infringement of human rights and an affront to British justice.
"It is unacceptable to deny a person freedom without even telling them what they are suspected of.
"We do not need to sacrifice the freedoms we have fought so hard for. We must not become what we are fighting.
"This discredited regime should be scrapped immediately. The Government should focus instead on making it easier to prosecute terrorists by making intercept evidence available in court."
It was the second time that the highest court in the land has scrutinised control orders.
In a ruling in October 2007, the Law Lords ruled that the most draconian power under the control order regime - an 18-hour home curfew - was in breach of the European Convention on Human Rights.
They said that a 12-hour curfew was acceptable, but Jacqui Smith, home secretary at the time, announced that she was looking at introducing 16-hour curfews instead.
In the second appeal, the terror suspects, who are subject to the new controls, challenged a ruling in the Court of Appeal last October when two of the three judges said terror suspects can be subjected to control orders even though they know nothing about the evidence against them.
Lord Pannick QC, who represented the first of the men identified only as AF, argued during the hearing that began in March that it was procedurally unfair to order him to stay in his flat on the outskirts of Manchester for up to 16 hours a day.
AF, who was born in 1981 in Derby and has dual Libyan and British nationality, cannot see anyone without permission or use the internet.
Lord Pannick said these conditions cannot be right if his defence lawyers are not told why he is suspected of terrorism so they can respond.
The second suspect, AN, is a British citizen, born in Derby in 1981 who moved with his wife to Syria where he was arrested and deported to the UK in March 2007.
AE is an Iraqi national who came to the UK in January 2002 and claimed political asylum.
Lord Phillips, in his ruling today, said 38 individuals had been subjected to control orders under the Prevention of Terrorism Act and it had generated "an extraordinary volume of litigation".
He said or the special hearings: "The care and industry devoted by both judges and advocates to ensuring the interests of the controlees are properly considered deserves recognition.
"It exemplifies the respect that is accorded by those involved in the administration of justice in this country both to human rights and to the rule of law."
He said it was the second time the case of AF had been before the House of Lords and the eighth substantial hearing it had received. "Nor will it be the last," he said.
Referring to the ECtHR decision in A v United Kingdom, he said it had been ruled that anyone facing a control order must be given sufficient information about the allegations against him to be able to give effective instructions.
The ruling was that, if the material in open court was purely general assertions and the case against the terror suspect was based on closed evidence, the right of a fair trial could not be satisfied.
Lord Phillips said: "Reasonable suspicion may be established on grounds that establish an overwhelming case of involvement in terrorism-related activity but, because the threshold is so low, reasonable suspicion may also be founded on misinterpretation of facts in respect of which the controlee is in a position to put forward an innocent explanation.
"A system that relies upon the judge to distinguish between the two is not satisfactory, however able and experienced the judge."
