Some 27 Labour rebels joined opposition parties to vote for a Liberal Democrat motion to give all Gurkhas who have served in the British armed forces equal rights to settle in the UK.
The 21-vote defeat was a humiliating reverse for Prime Minister Gordon Brown and a boost for the troops from the Himalayan kingdom of Nepal, who have pursued their demand for the right to settle through the courts over several years.
Liberal Democrat leader Nick Clegg said: "People who are willing to die for our country should be allowed to live in our country. The Government must listen to Parliament and scrap these shameful rules immediately and grant justice without conditions to all retired Gurkhas."
The Home Office announced last week that strict criteria would be applied to settlement claims for ex-Gurkhas discharged before July 1997. Applicants are to be judged according to length of service, bravery medals and service-related medical conditions.
Campaigners argued this would allow only around 100 veterans out of a total 36,000, most of them officers, to settle.
Mr Brown warned that the UK could not afford the £1.4 billion annual cost of an open-door policy.
"We have got to balance our responsibilities to those who have served our country with the finance that we need to be able to meet these obligations and not therefore base our offer on money we cannot afford," he said.
Gurkhas celebrate Commons victory - Yahoo! News UK
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It only took them 100s of years of
service to the crown to be deemed worthy of residency. This is a clear indication of, not only how little the Brits think of the foreign mercenaries that they recruit but also, how much trouble they are having recruiting new native soldiers and foreign mercenaries.
Deluded Paddies thinking about signing up as imperial mercenaries should take note.