However, only a fraction of those affected may receive compensation.
Legal filings indicated that 250,000 people had lost some Â£130m in benefits.
The Court of Appeal suggested the Department for Work and Pensions would owe a mere 1% of that amount, Â£1.3m, to just 2,500 people.
The complex judgment on Friday was originally prompted by a challenge from Cait Reilly, a geology graduate from Birmingham.
She had argued that requiring her to work at Poundland for no pay constituted a breach of her human rights.
The government - to counter such claims - had retrospectively altered the law to validate the docking of benefits.
Today, the Court of Appeal ruled that even under that new revised law, the docking of benefits could be incompatible with the European Convention of Human Rights.
The Court's ruling represented a defeat for the government.
Padraig Hughes, of Public Interest Lawyers, the group that brought Ms Reilly's case, said: "It is yet a further example of the reckless approach this Government continues to take towards the constitution and the rule of law."
The Court of Appeal judges did nevertheless acknowledge that government ministers can change laws to affect cases retrospectively.
And the judges decided that the only rights infringed upon where those of people that had already claimed the benefits docking was unfair.
This narrowing of the claimants explains why only a tiny fraction of people will be eligible for a payout.
"We are considering the judgment", a DWP spokesman said. "It is only right that jobseekers do all they can to find work while claiming benefits."
It is not clear yet whether either side will make a further appeal.
The government has lost the latest round of an extended legal battle involving the docking of benefits for jobseekers who refused to participate in unpaid back-to-work schemes.