The local government ombudsman ruled that there had been three cases of maladministration which resulted in injustice at the Islamia primary, in Kilburn, north London.
Governors at the school, founded by Yusuf Islam, formerly known as the pop singer Cat Stevens, have been told to pay each parent pound;100, offer them fresh appeal hearings, and to review their procedures.
Three parents said that the appeal panel, set up by the school's governors, failed to consider their arguments. They had appealed against the decision to refuse their children admission to the reception class in September 2003.
The ombudsman, Tony Redmond, found that published admissions criteria lacked objectivity and transparency. They had failed to explain to parents how their applications would be assessed, or what evidence should be supplied.
There was also "unreasonable delay" by the governors in holding the appeals.
No arrangements had been made so far to hold fresh appeals, despite a promise by the schoolto do so a year ago.
A letter sent by the governors to parents also contained incorrect information about the appeals process or why their applications had failed.
Flaws in the information sent to parents by the appeal panel clerk were "so serious and fundamental that the soundness of the whole appeal process was questionable", Mr Redmond said.
He has told the governors to seek advice from "a suitably qualified person" in reviewing their procedures and to take into account guidance in the relevant code of practice.
Abdullah Trevathan, the school's head, said the school had been unhappy with the admissions procedure for some time and that a review was already under way before the publication of the ombudsman's report.
"We would like to put in place an admissions procedure that is more like that of community schools than church schools. We also have to be mindful that we have a list of about 3,000 children wanting a place here," he said.
"We have processed thousands of applications in recent years so this report should be put in context - three parents have complained."