The coalition has suffered a shock defeat on a flagship policy as it prepares to mark its first anniversary in power.
Peers set the stage for a damaging showdown by rejecting plans for elected police commissioners by 188 votes to 176 - a majority of 12.
Many had expected Liberal Democrat rebels to win amendments insisting that the controversial measures were piloted before full introduction. Deputy Prime Minister Nick Clegg had already indicated he supported carrying out trials.
But shadow home secretary Yvette Cooper said the Lords had "ripped the heart out" of the legislation by going further and deciding police chiefs should be appointed rather than elected.
"David Cameron and (home secretary) Theresa May need to now recognise the strength of hostility and ditch the plans now," Ms Cooper said.
"The Government's policy would concentrate considerable power in the hands of one politician but with no proper checks and balances in place."
Under the Police and Social Responsibility Bill as it stood, police and crime commissioners (PCCs) were due to be elected from May next year to replace police authorities in England and Wales.
They would have the power to hire and fire chief constables and would set the police force's budget and "strategic direction".
But the amendment tabled by Lib Dem Baroness Harris of Richmond states that the commissioners should be chosen by a local police and crime panel.
Lady Harris, vice president of the Association of Police Authorities, said the plan for elected PCCs could do "irreparable damage" to the police service.