The House of Lords has rejected proposals in the Equality Bill that would have prevented religious organisations from discriminating against gay people.
Peers voted 216 to 178 against the government.
It wanted to restrict the refusal to hire people on the grounds of gender identity or sexual orientation to those who teach doctrine or lead worship.
Youth workers, teachers and other staff hired by religious groups would be protected.
The Archbishop of York told the Lords: "You may feel that many churches and other religious organisations are wrong on matters of sexual ethics.
"But, if religious freedom means anything it must mean that those are matters for the churches and other religious organisations to determine for themselves in accordance with their own convictions."
The government was defeated three times on the issue, and it is unclear if the provisions will remain part of the Equality Bill.
Tory backbencher Baroness O'Cathain, who moved the amendments against the government, said: "My package of amendments represents the legal status quo which is supported by the Church of England, the Catholic Church and others."
"Organisations that are based on deeply held beliefs must be free to choose their staff on the basis of whether they share those beliefs," she said.
"It would, for example, be appalling if the Labour Party could be sued for not selecting Conservative candidates and no one would want to see Greenpeace sued for refusing to appoint oil executives to its board of directors."
Baroness O'Cathain said that while she accepted that the government intended to protect the freedom of churches to choose their own staff, the wording of the Bill did not "mirror that intention".
Exemptions in bill allow churches to discriminate on the grounds of sex, sexual orientation and marital status when making appointments to key religious posts.
"An exemption along these lines has existed for more than 30 years. Some think that this is special pleading for the churches, but the principle of exemptions is widely accepted, not just for religion," she said.
394 peers turned out for the first vote, the largest number for a division since the Lords defeated the government over plans to plans to detain terror suspects for 42 days without charge in October 2008.
The Lord Bishop of Winchester said the issue for the churches and for people of some other faiths was of sexual behaviour, not of sexual orientation.
"This is not distinctly aimed at gay people, but at the question of sexual conduct, whether marital, heterosexual or homosexual," he told peers.
But Liberal Democrat Lord Lester of Herne Hill challenged the Bishop's distinction between behaviour and orientation.
He said: "The whole point of the relationship of being sexual partners is that you have an enduring and loving relationship in which sex is a perfectly normal activity.
"With respect, that distinction would not pass muster under European convention or European Union law."
And arguing against the amendments that led to the government defeat he said: "I believe the measures contained in the Bill accommodate the reasonable needs of the churches and other religious organisations to manifest their beliefs and practise their faith in accordance with their beliefs subject to the overriding requirement of proportionality.
"I find it quite astonishing and deeply depressing that the bishops should find the principle of proportionality, a principle deep in Christian ethics, a principle to be removed from this Bill. I'm frankly appalled that that should be the position."
But Labour peer Lord Alli said "simply by being gay" the law allows religious organisations-in this case the employer-to sack a priest, in this case the employee.
"So even where a gay man takes a vow of celibacy, the law still allows for his dismissal," he said.
"The law is not about adultery; it is not about sex outside of marriage; it is not even about gay sex. It simply allows for the dismissal of the individual for being gay.
"I am not sure that is what we intended when we wrote the Bill. It is like saying it is all right to be sacked for simply being black. How can that be right?"
Baroness Sayeeda Warsi, the Conservative shadow minister for community cohesion, hailed the vote as a "victory for common sense".
