Friday's ruling by the the National Green Tribunal is expected to further set back the US$12-billion project in mineral-rich Orissa state – the largest foreign investment commitment to India which was first announced in 2005.
The decision by the government-appointed panel is likely to fuel further unease among foreign companies about India's regulatory environment that has been heightened by retroactive tax measures proposed this month.
"The environment clearance granted on January 31, 2011 to the project shall remain suspended till such a review and appraisal is done by the ministry," Justices C.V. Ramulu and Devendra Kumar Agarwal ruled.
The proposed plant in Jagatsingpur, a coastal district 100 kilometres (60 miles) east of the state capital Bhubaneswar, has been the focus of protests since POSCO signed its initial deal with the Orissa government.
The tribunal noted the agreement between the Orissa government and POSCO refers to a plant able to produce 12 million tonnes of steel annually.
But the environmental impact report was prepared looking only at the first phase of the plan to produce four million tonnes a year, the justices said.
"The environmental impact assessment should assess it (the project) for the full capacity right from the beginning," they said.
The order passed by the National Green Tribunal, set up two years ago to handle environmental disputes, following a plea filed by an environmental activist.
It suspends clearance to the project granted a year ago by then federal environment minister Jairam Ramesh.
Locals say the plant will interfere with their traditional forest-based livelihoods and uproot them from their homes.
The POSCO deal has been watched as a test case by foreign investors eager to enter India's fast-growing economy but wary of the potential for environmental and other concerns to derail their plans.
Billions of dollars worth of projects have been delayed due to problems over environmental clearances and land acquisition in recent years.