The three-judge panel of the 3rd U.S. Circuit Court of Appeals ruled that the Federal Communications Commission "acted arbitrarily and capriciously" in issuing the fine for the fleeting image of nudity.
The 90 million people watching the Super Bowl, many of them children, heard Justin Timberlake sing, "Gonna have you naked by the end of this song," as he reached for Jackson's bustier.
The court found that the FCC deviated from its nearly 30-year practice of fining indecent broadcast programming only when it was so "pervasive as to amount to 'shock treatment' for the audience."
"Like any agency, the FCC may change its policies without judicial second-guessing," the court said. "But it cannot change a well-established course of action without supplying notice of and a reasoned explanation for its policy departure."
The 3rd Circuit judges - Chief Judge Anthony J. Scirica, Judge Marjorie O. Rendell and Judge Julio M. Fuentes - also ruled that the FCC deviated from its long-held approach of applying identical standards to words and images when reviewing complaints of indecency.
"The Commission's determination that CBS's broadcast of a nine-sixteenths of one second glimpse of a bare female breast was actionably indecent evidenced the agency's departure from its prior policy," the court found. "Its orders constituted the announcement of a policy change - that fleeting images would no longer be excluded from the scope of actionable indecency."
A CBS spokeswoman said the company was working on a statement Monday morning. Messages left for an FCC spokesman were not immediately returned.
At the time, broadcasters did not employ a video delay for live events, a policy remedied within a week of the game.
In challenging the fine, CBS said that "fleeting, isolated or unintended" images should not automatically be considered indecent.
But the FCC argued that Jackson and Timberlake were employees of CBS and that the network should have to pay for their "willful" actions, given its lack of oversight.
In June 2007, a federal appeals court in New York invalidated the government's policy on fleeting profanities uttered over the airwaves. The case involved remarks made by Cher and Nicole Richie on awards shows carried on Fox stations.