The local authority wanted a court declaration saying Muslims are covered by offences relating to the Public Order Act, as a racial group under the Race Relations Act.
The council took action after the Crown Prosecution Service decided not to prosecute Paul Ballard, Croydon branch organiser of the British National Party, over stickers asserting 'Rights for Whites' and leaflets campaigning against the conversion of an old dairy into a mosque.
Mr Ballard had been charged with possessing written material stirring up racial hatred under s23 of the Public Order Act. But the CPS concluded that, while the law was uncertain, Muslims were a religious rather than an ethnic group, and therefore not covered by the Race Relations Act or race protection laws in the Public Order Act.
Jews and Sikhs have the protection of the race laws because earlier cases declared them to be racial groups. One lawyer said: 'You're left with the absurd situation that you can be as rude as you wish against Muslims but you're not allowed to abuse Jews or Sikhs.'
Geoffrey Robertson QC for the council said: 'This means that around 2m Muslims, citizens of this country, are not protected.'
Merton LBC is expected to make a new application before two or three high court judges. Sheila Knight, the deputy leader, said: 'I am extremely disappointed the high court has not taken this opportunity to investigate ...a review would have afforded a unique opportunity for an in-depth look at the act.'