The Supreme Court's decision could strain Pakistan and India's already brittle relationship at a time when the rival nations are trying to restart peace talks. It's unclear if Islamabad will try again to go after Hafiz Mohammad Saeed.
Saeed was one of the founders of Lashkar-e-Taiba, a militant group banned in 2002 and blamed in the 2008 attack that left 166 dead in India's financial capital. He now leads a charity that the U.N. alleges is a front for the militant organization and which the government says it has also banned.
The government had petitioned the Supreme Court to overturn lower court decisions that also found a lack of evidence against Saeed and released him from house arrest in the eastern city of Lahore.
The top diplomat in India's External Affairs Ministry said she was disappointed by the decision.
"We regard Hafiz Saeed as one of the masterminds of the Mumbai terror attack. He has openly urged jihad against India," said Foreign Secretary Nirupama Rao. "Enough evidence also has been given by India to Pakistan about the role and activities of Saeed."
A.K. Dogar, Saeed's lawyer, said the Supreme Court issued a short order saying the government had failed to produce any evidence that his client played a role in the attack or had links to terror groups.
Prosecutor Saeed Yousuf said government authorities did not give his team enough material to make a better case against Saeed.
Jamaat-ud-Dawa's spokesman, Yahya Mujahid, said the decision lifted the stigma from the charity.
"With the grace of God, the court ruling in our favor proves that Jamaat-ud-Dawa, its chief and its workers are not terrorists," Mujahid said.
Pakistan has put seven men on trial on charges they assisted in the Mumbai siege, while India has convicted and sentenced to death the sole survivor of the 10 gunmen who carried out the massacre over three days in November 2008. Still, New Delhi wants to bring Saeed and others it alleges were higher-ups in the plot to justice.
The two countries have fought three wars since their independence from Britain in 1947, and Pakistan long groomed militants like Saeed to act as so-called "freedom fighters" against India in the disputed territory of Kashmir. Many in India suspect Pakistan is dragging its feet on punishing Saeed, while Pakistan insists India should offer more evidence to help its case against the cleric.
Three weeks ago, Indian Prime Minister Manmohan Singh and Pakistani Prime Minister Yousuf Raza Gilani agreed to resume peace talks and work toward rebuilding trust shattered by the Mumbai attacks.
The U.S. wants to ease tensions between the two countries in part to give Pakistan room to redirect more of its soldiers and military resources toward fighting the Taliban and al Qaeda on its northwestern border with Afghanistan.