The Deputy Prime Minister made a fundamental factual error when he said 'Yes' to the 22,000-seat arena last October and will now reconsider the application.
Lawyers for Lewes District Council pointed out the mistake in their evidence to the High Court, where they were seeking a judicial review of the planning permission.
A spokesman for the Office of the Deputy Prime Minister (ODPM) said Mr Prescott acknowledged he had made an error in his decision letter, when he said 'Yes' to Falmer.
As a result, his office has decided not to challenge Lewes District Council's legal action.
The spokesman said: 'Instead, the planning permission will be rescinded and the Secretary of State will make a new decision.
'This does not mean the original decision was wrong. We have conceded because of a technical error, not because of the substance of the decision.'
In his approval letter, Mr Prescott made a number of references to the stadium being inside the development boundary of Brighton and Hove as designated by the local plan.
But Lewes District Council pointed out only a small part of the stadium site at Village Way was inside the boundary.
It was understood to be the council's key argument in its attempt to get the stadium permission overthrown in the High Court in a joint action with Falmer Parish Council and the South Downs Society.
Anti-stadium campaigners are claiming victory but Albion bosses said fans had nothing to worry about and the news was likely to actually speed up the long-running stadium saga.
Albion Chief Executive Martin Perry said: 'The club is pleased that the Treasury Solicitor has decided to take this route.
'Although it will give a Pyrrhic victory to Lewes, this is the most sensible and quickest route out of the mess Lewes have created, because the club will not have to wait for a court hearing, or the time it takes for the judgement to be made. It is only a minor technicality and was not a determining factor in the decision.'
He said it would not affect the club's latest target of opening the £50 million arena in time for the 2009/10 season.
Club chairman Dick Knight added: 'It is extremely frustrating that Lewes have been be able to delay the process on a technicality. I fail to understand why they should be so hostile towards the stadium, which will bring massive sporting, social and economic benefits, not just to Brighton and Hove but to the whole of Sussex including Lewes.'
Mr Prescott will now invite the football club, Lewes District Council, Brighton and Hove City Council and other parties to the planning inquiry to submit written evidence on the mistake.
The ODPM could not say how long that would take or what the outcome would be, but Mr Perry predicts the club will have final, water-tight planning permission by August this year.
But if Mr Prescott says 'Yes' again there is a chance Lewes District Council could seek another judicial review.
The boundary issue was not the only point made by the council in its evidence to the High Court. It also questioned whether Mr Prescott was right to allow development on a legally-protected landscape and that he failed to recognise other suitable sites, like Sheepcote Valley and Toad's Hole Valley.
The ODPM spokesman added: 'The Secretary of State does not concede on any of the other grounds of challenge that Lewes District Council have made.'
Norman Baker MP, who opposed the Falmer site, said: 'It seems like a pretty major mistake to make and it will mean more unwelcome uncertainty for both the club and the people of Falmer. I'm not surprised in one way because the ODPM is the most useless department in the Government and John Prescott is a buffoon.
'Whatever happens now we need a decision in the shortest possible time. This can't go on indefinitely.'
Tim Carder, chairman of Brighton and Hove Albion Supporters' Club, said: 'Congratulations to Lewes, it looks like they will have won the day on this one technicality.
'But Mr Prescott wording his decision incorrectly doesn't alter the fact the stadium was approved because it significantly helps the regeneration of a deprived area. It is still in the national interest, and it was given the go-ahead because the benefits hugely outweigh the harm to this nondescript, urbanised part of the Area of Outstanding Natural Beauty.'
Falmer For All campaigner Ed Bassford sounded a warning note, saying: 'A lot will depend on whether or not Lewes District Council accepts the other points it made were invalid.
'If not then they could well seek another judicial review if Mr Prescott says yes again.'
A spokesman for Lewes District Council was unavailable for comment last night.
-----
From www.clubsincrisis.com
