Rebels from Mr Blair's Labour Party joined opposition lawmakers in the House of Commons in rejecting, by a margin of 31 votes, plans to allow police to hold terror suspects for up to 90 days without charge.
A compromise proposal for terror suspects to be held for 28 days without charge, up from the current 14 days, was passed instead.
It was the prime minister's first defeat on a legislative proposal in the lower house since he swept to power in 1997.
Members from both the Labour Party and the opposition said Mr Blair had seriously misjudged lawmakers by sticking to the 90-day proposal.
The defeat was all the more severe as Mr Blair had put his personal authority on the line to pull his party with him, and citing a "compelling" case in the wake of the July 7 London bombings.
He played down suggestions by opposition leaders and others that his grip on power was slipping.
"I don't think it's a matter of my authority," Mr Blair told the BBC when asked if the vote was a blow to his position. "Of course, I would have preferred to have won rather than lost."
Instead, he said he hoped lawmakers would not regret their decision. "I really do think people in the country will find it a strange decision" for MPs to take "given such a strong and compelling case by the police."
Michael Howard, the leader of the Conservative opposition, suggested Mr Blair should review his position.
Media analysts have also speculated that Mr Blair may have to step down before serving out his third term.
Vote on terror laws
Other aspects of the legislation were to be voted on later including a ban on glorifying terrorism, selling extremist books, receiving or providing terrorist training, or preparing to commit attacks.
The prime minister had argued before the Commons that longer detentions would help police glean more evidence, build stronger cases and "may be the crucial difference in saving this country from terrorist acts."
Police called for longer powers of detention following the London bombings because of wider use of encrypted computers, as well as language difficulties inherent in combating international terrorist networks.
Since the attacks on July 7 by four presumed Muslim suicide bombers who killed themselves and 52 commuters in London, the threat of more attacks still looms, Mr Blair warned.
"In the last week, we have learned that since the 7th of July two further terrorist plots have been prevented in this country," he said.
The Conservative and Liberal Democrat opposition parties as well as human rights groups had denounced the detention plans.
Home Secretary Charles Clarke proffered a "sunset clause" which would see the legislation expiring in 12 months unless renewed by lawmakers.
Mr Clarke also offered the stipulation that a suspect's detention would be reviewed by a High Court judge every seven days and a code of practice to govern the treatment of those held.