The Government suffered a shock defeat today over the right of the Gurkhas to settle in the UK.

Despite last-minute concessions that bought off some Labour MPs, a Liberal Democrat move to scrap new settlement criteria for Gurkha veterans was backed in the Commons today by 267 votes to 246, a majority of 21.

The decision is a massive embarrassment for Gordon Brown and the first defeat of his premiership. MPs gasped when it was announced, believing that the concessions by the Home Secretary would be enough.

Jacqui Smith promised to start a review of criteria by the summer, and said it was highly unlikely that any veterans whose cases were under review would be deported.

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But the moves were not enough and, amid delighted cheers from Liberal Democrat and Conservative MPs, the Government went down to defeat.

Nick Clegg, the Liberal Democrat leader, said outside the House of Commons. "It's victory for decency, it's the kind of thing I think people want this country to do, that we pay back our obligation our debt of gratitude," he said. "It was great, great day for everyone who believes in fairness and decency in this country".

Mr Clegg, standing alongside the actor Joanna Lumley who has long campaigned for the Gurkhas, said the Government would now have to change its stance on the issue. "Now they've got a vote from MPs from all parties saying you've got to change this, think again, this is downright wrong. They will have to change it and change it fast," he said.

Earlier, Mr Brown faced pressure from all parts of the Commons at Prime Minister's Questions. David Cameron, the Conservative leader, Mr Clegg and Labour MPs pressed the Prime Minister to open the way for the entry of more soldiers.

Mr Brown insisted that 4,000 veterans and their families – a total of 10,000 people – would be allowed to enter, and contested claims by campaigners that the figure could be as low as 100. He said that public expenditure constraints had to be borne in mind, but that £1.4 billion had been put aside to meet the costs.

In an attempt to appease the rebels, Mr Brown said there would be regular reviews of the system and added that the Government was sympathetic to the Gurkha case, which would be looked at in the next few weeks. He also said that many of those being allowed in were below officer rank. But Mr Brown’s concessions failed to win over critics and defeat his backbench rebellion.

Andrew Mackinlay, Labour MP for Thurrock, said Gurkha soldiers were of “enormous benefit” to the UK. He told ministers it was inevitable the campaign to win better settlement rights would ultimately succeed. “Why don’t you embrace it now. If it was painted on your eyelids, you wouldn’t understand a just policy or a popular policy,” he said.

Mr Cameron said that recent changes to Gurkha settlement rules were “too restrictive” and did not honour the obligation to the soldiers or command public support.

“Today is an historic day when parliament took the right decision. The government now have got to come back with immediate proposals,” he said in Parliament Square.

Although the vote is not technically binding, it comes as a serious blow to the Government. The defeat comes less than a week after the Home Office disclosed new criteria for settlement claims for Gurkhas, which many had confidently expected would allow tens of thousands to settle in the UK.

When the announcement was made it was to general astonishment at the lack of generosity shown by the Home Office and cries of "betrayal" from supporters of the Gurkhas.

The new criteria was announced after the High Court had ruled that the previous rules were unlawful and should be reviewed urgently.

Under the new rules based on long service, bravery medals and service related medical conditions, campaigners for the Gurkhas said they would benefit no more than 100 of the 26,000 or so veterans. Settlers must fulfil one of three criteria: three years continuous residence in the UK, close family in Britain, a bravery award including VC, DSO, or MC, 20 years service or a long term condition caused or aggravated by service.

However, the Home Office insisted that it would allow 4,000 Nepalese soldiers who were discharged before 1 July 1997 in plus 6,000 dependents.

There are 26,500 ex-Gurkhas receiving a Ministry of Defence pension in Nepal and until 2004 they were not allowed to settle in the UK. The ban was lifted for the Gurkhas who retired after July 1997, when the brigade HQ left Hong Kong but soldiers who retired earlier were only given the right to stay in Britain in very exceptional circumstances.

The Liberal Democrat motion pointed out that more Gurkhas had died fighting for Britain over the years than were believed to want to come to live here and called for a blanket settlement right.

Ms Lumley, whose father served in a Gurkha regiment, said: “Just before this vote was taken our spirits were nearly at zero.

“When it came through... I can’t tell you the sense of elation, the sense of pride - pride in our country, pride in the democratic system and pride in our parliament."

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