The decision is seen as a key victory for the European competition regulator, and a serious blow for the US software giant, in the long-running competition dispute.
The European Court of First Instance rejected Microsoft's appeal against a record €497million fine imposed by the European Commission three years ago.
The court upheld an earlier 2004 ruling that Microsoft had abused its dominant market position, using its dominant 95% market share of the personal computer operating systems market to freeze out rivals.
The court upheld the earlier ruling that the software group had broken competition rules in two ways.
The first type of conduct found to constitute an abuse was Microsoft's refusal to supply rival companies with "interoperability information" – crucial information about the Windows operating system.
By way of remedy the Commission requires Microsoft to disclose the "specifications of its client/server and server/server communication protocols to any undertaking wishing to develop and distribute work group server operating systems."
The second breach was that by bundling its Windows Media Player with the Windows PC operating system, this undermined competition from other media player providers.
By way of remedy here, the Commission requires Microsoft "to offer for sale a version of Windows without Window Media Player."
The court's statement said: "The Court of First Instance essentially upholds the Commission's decision finding that Microsoft abused its dominant position."
The court also upheld the fine imposed on Microsoft for anti-competitive practices in the 2004 decision. The court ruled that the Commission was justified in "assessing the gravity and duration of the infringement and did not err in setting the fine."
The latest ruling – which comes after a nine year legal battle - was made by the 13-judge Grand Chamber of the Court if First Instance in Luxembourg. The importance of the ruling was underlined by it being broadcast live on television – a first for such a decision.
Although the ruling of the Court of First Instance on facts is final, Microsoft has two months to appeal on matters of law to the European Court of Justice – the EU's highest court.
The court threw out just one small part of the European Commission ruling, reversing a decision on the creation and funding of an independent monitoring trustee, effectively to supervise Microsoft's behaviour.
Industry experts say the ruling will have big repercussions not only for the regulator, but for Microsoft and its rivals.
If the ruling had not been upheld it would have been seen to seriously weaken the European Commission's ability to pursue fresh cases against Microsoft and other dominant groups.
Guy Lougher, national head of the EU & Competition Group at Pinsent Masons, the law firm behind OUT-LAW.COM, said the verdict would have major consequences for other similar cases stuck in the court system.
"As matters currently stand, the Court of First Instance's judgment will invigorate the European Commission and national competition authorities across the EU, which have been soft-peddling in relation to a number of ongoing cases in the software and other industries pending the CFI's judgment.
"We can expect to see the principles of the case now being rolled-out more actively in national courts and by national competition authorities within the EU. The case clearly has implications for the software industry, where the commercial practices of a number of large companies are already under review, such as Intel, Rambus and Apple.
"However, the bundling aspects of the case will need to be reviewed carefully by large incumbent operators in other industries who sell goods or services only as a package, but where there is a demand to purchase them separately, if the bundling adversely affects rivals and where there is no objective justification for the bundling."
Microsoft's rivals welcomed the court decision. Thomas Vinje, the legal representative of ECIS - a group which includes IBM, Nokia, Oracle and Sun Microsystems – told FT.Com: "This is a great day for European businesses and consumers.
"At long last, the decision opens the prospect for dynamic competition in the software industry. No more user lock-in, no more monopoly pricing."
The Free Software Foundation Europe (FSFE) said the verdict was "a triumph for freedom of choice and competition." Georg Greve, president of FSFE, said: "Microsoft can consider itself above the law no longer.
"Through tactics that successfully derailed antitrust processes in other parts of the world, Microsoft has managed to postpone this day for almost a decade. But thanks to the perseverance and excellent work of the European Commission, these tactics have failed in Europe."
Greve added that the decision was "a very important precedent" for the future. "Secret manipulation of open formats and protocols has clearly been marked as unacceptable conduct."
In its immediate response to the ruling, Microsoft said it was important now for the company to comply with European competition law. Brad Smith, senior vice president and corporate secretary, said: "It is clearly very important to us as a company that we comply with our obligations under European law.
"We will study this decision carefully and if there are additional steps that we need to take to comply with it we will take them."
Speaking in Luxembourg, Smith did however point out that "a lot has changed" since the case started back in 1998. He said: "The world has changed, the industry has changed and our company has changed.
"To underscore that, over a year ago we published our ''Windows Principle' to ensure that future versions of Windows – starting with Windows Vista – would comport not only with the principles of US law but also European law. We sought to be open and transparent and strengthen our ties with the rest of our industry.
Smith concluded: "One thing that has remained constant and will continue to do so is Microsoft's commitment to Europe.
"When this case started we published Windows in 24 European languages, today that is 42. When the case started we had 3,900 employees in Europe, today it is 13,000. When the case started we were spending $3 million on research and development, today it is almost half a billion dollars. These numbers will continue to grow.
"We look forward to continued efforts to implement and comply with the decision, and we look forward to hopefully continuing to move technology forward and creating more jobs in this continent."