The victory could bring down the shaky coalition of Prime Minister Ariel Sharon and lead Israel into early elections.
The surprise result of the cliffhanger primary election was announced at dawn at the party's Tel Aviv headquarters.
Party secretary Eitan Cabel announced that the Labour leader captured over 42 percent of the vote, while Mr Peres gained just under 40 per cent.
A third candidate, former party leader and Infrastructure Minister Binyamin Ben Eliezer, gained less than 17 per cent of votes of the 100,000 Labour party members.
Mr Peres, a historic figure in the party, had overnight contested the results from some voting offices and the party's electoral commission took this into account, however rejected his fraud allegations.
Mr Peres, the current party leader, wants Labour to remain as the junior partner in Mr Sharon's government.
Mr Peretz wants to steer the party closer to its socialist roots and has signalled a desire to withdraw the party from the coalition and force elections before their scheduled November 2006 date.
Labour backed Mr Sharon's Gaza pullout, an action which divided his Likud party.
Nobel laureate Mr Peres, 82, is a political veteran and had been widely tipped to hold onto the leadership, particularly after fellow rival minister without portfolio Matan Vilnai and former prime minister Ehud Barak dropped out of the race.
Mr Peretz, 53, heads Israel's main trade union organisational, Histadrut, and will become Labour's candidate for prime minister in the next general election.