The 9th Circuit Court of Appeals said Donald Trump’s anti-immigration policy could not be applied in the nine states that make up the circuit, which includes two states (California and Arizona) that are on the border with Mexico.
There was a partial win for the Trump administration as the court stopped short of applying its ruling nationwide and left open the possibility of the ban being applied in the other states which border Mexico - Texas and New Mexico.
Mr Trump’s policy would require most asylum-seekers to first seek safe haven in a third country, such as Mexico or Guatemala, before coming to the US.
The court ruling came on the same day that California and other states, as well as a coalition of advocacy groups, filed lawsuits to stop a separate plan to reduce legal immigration by denying visas to poor migrants.
The lawsuits are challenging a rule that would deny or revoke visas for legal immigrants who might become a “public charge” due to failing to make enough money or receiving public assistance, such as welfare, food stamps or public housing.
Mr Trump has made reducing immigration, particularly by Central American migrants along the US-Mexico border, a central issue of his presidency.
On 24 July, US District Judge Jon Tigar issued a preliminary injunction in San Francisco to prevent the asylum applications proposal taking effect.
The government appealed the decision but a three-judge panel ruled on Friday that the Trump administration had failed to comply with portions of the law that govern rule-making.
"The court properly refused to let the new asylum ban go into effect, though currently limited to the 9th Circuit. We will continue fighting to end the ban entirely," Lee Gelernt, an attorney for the American Civil Liberties Union, said in a statement responding to the ruling.
The White House said it “strongly” disagreed with the decision and hoped the injunction would be lifted on appeal.
"While the injunction remains overbroad - even as modified by the 9th Circuit's decision - we will now be able to apply the rule at issue to curb asylum abuse outside of the 9th Circuit," Stephanie Grisham, White House press secretary, said in a statement.
It is thought that the ruling could encourage more asylum-seekers to attempt to cross the border at California and Arizona rather than Texas and New Mexico.
The Trump administration has claimed it needs to curtail asylum cases because the vast majority are found to be without merit.
However, opponents have warned it is unrealistic to expect people fleeing persecution to seek asylum in countries such as Mexico or Guatemala, which are ill-equipped to deal with large numbers of migrants.
Agencies contributed to this report