Sex shop owners have won a High Court victory over licensing fees which could see them claw back an estimated £1 million.
A judge ruled today that Westminster City Council unlawfully used licence fee income to enforce against illegal sex shops.
Mr Justice Keith declared that a recently introduced European directive did not permit the determination of "a reasonable licence fee" to include the costs of enforcement.
It is understood the decision, which has wide ramifications, has left Westminster council alarmed that powers granted to democratically-elected councils have apparently been superseded by a European directive.
Tony Devenish, the council's Cabinet member for licensing and public health, said: "Naturally we are disappointed at this decision, which we intend to appeal.
"Westminster City Council has always maintained that the use of licence fee income to enforce against illegal sex shops is a proper use of public money, protecting the quality of life for our residents and visitors, including the global reputation of London.
"Enforcing against the illegal sex trade actually benefits those who are legitimate operators in the sex industry.
"With millions of extra visitors about to descend on London to celebrate the Jubilee and Olympics, it is critical people see the best face of our city."
Today's landmark ruling was a victory for Simply Pleasure Ltd and six other long-standing licensees of 11 sex shops in London's Soho and two others in Covent Garden and the West End selling adult sex toys, DVDs, and books and magazines.
The judge observed: "When people of my generation hear the word Soho, they tend to think of seedy clubs and illicit sex.
"But the sex industry is now highly regulated."
The judge said that in the past the cost of enforcing the licensing system was often reflected in the licence fee.
But in 2009 new regulations were introduced to implement EU Directive 2006/123/EC, which was aimed at creating "a free and competitive market for services within the European Union".
The judge said that "whatever domestic law had permitted in the past", the directive did not allow the licence fee to exceed the administrative costs covering "the steps which an applicant for a licence has to take if he wishes to be granted a licence or to have his licence renewed".
Since 1999 Westminster Council has closed 68 illegal sex shops.
The council spokesman said: "This is part of our determination to regulate the industry in Soho and ensure London is at its best ahead of this summer's celebrations."
The judge acknowledged that the sex shop-owners who brought today's challenge were the beneficiaries of the council's licensing system.
"Effective enforcement means that they do not have to worry for long about unlicensed competitors," he said.
"Since they get much of the benefit of that enforcement, should they not have to pay for at least some of it?
"I see the force of that, but it does not necessarily follow that those who benefit from a service provided by a local authority should have to pay for it.
"Many services are funded from the local authority's general fund, whether the source of that fund is the council tax paid by local residents or businesses or funding from central government, especially when the community as a whole benefits from that service.
"The fact that the council has preferred over the years to use the licence fee to charge the operators of sex establishments for enforcing the system does not affect the proper interpretation of the 2009 regulations.
"For all these reasons, therefore, I have concluded that since the year beginning February 1 2010 the council has not been permitted, when determining the reasonable licence fee for sex establishments, to reflect the fee which it determines the costs of enforcing the system."