The Lodge Hill site, former Ministry of Defence (MoD) land on the Hoo Peninsula, had been allocated as a 5,000-home community in the authority's emerging core strategy.
But in March, the government's conservation adviser Natural England said it would designate the location as an SSSI because of the presence of nightingales.
This week, the council was told by the Planning Inspectorate that, because of this, and the lack of alternative sites, the document should be withdrawn and a new plan drawn up.
The site would have provided almost a quarter of new housing development in the council area over the plan period. An outline application for the scheme was submitted by developer Land Securities in November 2011.
In her letter to the council, inspector Laura Graham said the Lodge Hill allocation "and the lack of any contingency", plus "the shortcomings relating to objectively assessed needs", means the plan would have to be rewritten.
She said: "I consider the changes required are so significant that I am unable to deal with the matter through main modifications and that the only reasonable course of action is for the council to withdraw the core strategy and prepare a new local plan."
The council reacted angrily to the decision, claiming the work gone into the core strategy has so far cost the council £2 million. A spokeswoman said a further £25 million had been spent by the Department for Communities and Local Government on the site in question, although she was not able to provide details of what the money had been spent on.
In a statement, the council said it had "explored and consulted on" alternative development sites in Medway, but none were as suitable as the previously developed brownfield land at Lodge Hill.
It said development of the site would have created 5,000 jobs and that environmental organisations, including the Royal Society for the Protection of Birds (RSPB) and Natural England, have been closely consulted from the outset.
The RSPB raised concerns about the presence of nightingales at the site last August during the core strategy examination.
Rodney Chambers, council leader, said: "Despite ministers from the past and current governments supporting the development of Lodge Hill, their unelected quangos seem intent on throwing a spanner in the works, which quite simply beggars belief.
"It is surprising and frustrating that this has been delayed in this way at the 11th hour.
"It is unthinkable that more than £35 million pounds, which has been invested by the government, Medway Council and the developer to ensure the viability of this project, could now simply be written off."
Chambers said the council has worked on the Lodge Hill proposal for 17 years since the site was first identified by the government for development.
He said the decision would cost local people homes and jobs and called on the government to take action to move the proposal forward.