The Court of Appeal in London found that Ministers had failed to properly assess the role of military equipment in civilian casualties during Saudi's bombing in Yemen.
It concluded that it was "irrational and therefore unlawful" for the Secretary of State for International Trade to have granted licences without making any assessment about international humanitarian law violations, Efe news reported.
Presenting the verdict, Master of the Rolls Sir Terence Etherton said "the government made no concluded assessments of whether the Saudi-led coalition had committed violations of international humanitarian law in the past, during the Yemen conflict, and made no attempt to do so."
Judges said that export licences to Saudi do not need to be immediately suspended but that a review should be carried out before any further are issued.
"It does mean that the UK government must reconsider the matter, must make the necessary assessments about past episodes of concern," the statement added.
"The government must then estimate the future risks in light of their conclusions about the past."
It was a victory for protest group Campaign Against Arms Trade (CAAT) which accused the British government of risking breaching international humanitarian law by licensing the sale of arms.
"This historic judgment means that the government must now stop issuing new arms exports licences, and retake all decisions to export arms to Saudi in accordance with the law," CAAT said in an online statement.
"We celebrate this historic verdict. But these weapons sales should never have been licensed in the first place. It should not take a group of campaigners taking the government to court to force it to apply its own rules."
Spokesman Andrew Smith described the Saudi regime as "one of the most brutal and repressive in the world" and said that for decades it had been the main buyer of arms from the UK.
He added that the Yemen bombings created the "worst humanitarian crisis in the world" which UK arms companies have benefited from.
"Arms sales must stop immediately," he said.
The Department for International Trade said it disagreed with the judgment and intends to launch an appeal.
A spokesperson said: "This judgment is not about whether the decisions themselves were right or wrong, but whether the process in reaching those decisions was correct."
The UK has licensed more than 4.7 billion pounds of arms exports to the Saudis since the bombing of Yemen began in March 2015. Equipment had included Typhoon and Tornado fighter jets and precision-guided bombs.
( With inputs from IANS )