The opposition Labour party led the rare rebellion in the upper chamber House of Lords in a vote on removing existing "nutrient neutrality" rules.
The government says that up to 100,000 new homes could be built before 2030 if water pollution rules are eased -- a claim disputed by opposition parties.
"Don't pretend it's a choice between looking after our environment and building more houses, because it isn't," Labour's Nick Thomas-Symonds told BBC radio.
Defeat in the unelected Lords usually means the proposal bounces back the elected lower House of Commons for another vote.
But due to the way the government introduced the plan, it would now have to be brought forward in a new bill.
Labour's deputy leader Angela Rayner said the government had "utterly failed in their attempt to score cheap political points with a flawed plan".
But senior Conservative minister Michael Gove said Labour had blocked "the dream of homeownership for thousands of families".
Current rules, a relic of the UK's membership of the EU, mean 62 local authorities cannot allow new developments unless projects in protected areas can be shown to be "nutrient neutral".
The government is under pressure to increase the country's housing stock, after warnings earlier this year that housebuilding could fall to its lowest level since World War II.
The industry has blamed over-strict enforcement of EU environmental regulations.
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