The Delaware & Raritan Canal Commission (DRCC) voted, 4-3, against a waiver for the housing, citing its encroachment on a stream corridor.
But the Princeton-based institute, where Albert Einstein was once a faculty member, isn't giving up, officials said.
It remains "focused on this particular parcel" and "committed to seeing the process through," said spokeswoman Christine Ferrara. "We feel confident that this won't prevent us from moving ahead."
The commission's decision, though, was clearly a blow to the project, said the Princeton Battlefield Society, a nonprofit including scholars, preservationists, and environmentalists who have opposed the housing proposal since it first came before the Princeton Regional Planning Board in 2003.
"Right now, the project is dead," said Bruce Afran, the group's attorney. "They cannot build and have no permits to build.
"They pretty much have to start over," he said, "That process takes many years."
The institute had planned to build 15 housing units, screened by trees on seven acres, and permanently preserve 14 adjacent acres.
Its proposal also called for archaeological work to recover artifacts, a 200-foot buffer zone next to the park, interpretive markers, and removal of trees and brush not present at the time of the 1777 battle.
"We've had aspirations since the 1970s to build on this land," said Ferrara. "It's the only place the housing should be put."
The Princeton Battlefield State Park would not exist if the institute had not provided much of the land to the state in 1973, officials said.
The sale of the 32 acres was made based on a commitment that the institute's land east of the battlefield state park's boundary could be used as a future site of housing, officials said.
"We have been very sensitive to the battlefield park," Ferrara said. "We helped create the park as it stands."
The proposed additional housing - eight townhouses and seven single-family houses - would allow faculty members to spend more time on campus and encourage collaboration between them and visiting scholars.
Einstein was a faculty member from 1933 to his death in 1955, and sometimes walked to the campus from his home less than a mile away.
For history buffs and preservationists, though, the institute land at the center of the dispute is sacred ground.
"The Battle of Princeton was a seminal event in American history, being a humiliating defeat of British regulars by Washington, won in the course of a brilliant 10-day strategic campaign beginning with the First Battle of Trenton and culminating with Princeton," said Jerry Hurwitz, president of the Princeton Battlefield Society, which "is dedicated to preserving the core area of that battlefield, a good portion of which is threatened" by the planned housing.
The American victory at Princeton on Jan. 3, 1777, followed a success over Hessian mercenaries at Trenton on Dec. 26, 1776.
Washington strategically redeployed his army after another clash at the Second Battle of Trenton on Jan. 2, 1777. That night, he marched around the British army's left flank to attack its rear at Princeton.
At one point during the fight, Washington urged his soldiers on. "Will you give your general to the enemy?" he asked, according to historical accounts.
"They faced about, and the arms were leveled at both sides - Washington between them - even as though he had been placed between them as a target for both," wrote an American colonel who was there.
"Instantly there was a roar of musketry followed by a shout," the officer wrote. "It was the shout of victory. On raising our eyes, I discovered the enemy broken and flying, while dimly, amid glimpses of the smoke, was seen Washington alive and unharmed, waving his hat and cheering his comrades in pursuit."
"Where Washington may have been riding that day, the institute wants to build houses," Hurwitz said.
That event "makes this piece of property vital to American history," Afran said. "The national interest takes priority.
"I don't know a single university that would destroy a historic site to build houses for faculty," he said. "Human beings fought and died there."
The DRCC's action "was a big decision for us," said Kip Cherry, first vice president of the Princeton Battlefield Society. "It effectively saves the counterattack site, but we won't rest on our laurels."
Opponents are considering new court challenges involving environmental concerns about the area's wetlands. The institute "faces years of renewed litigation" if it pursues the project, Afran said.