Impossible conditions demanded by America meant the UK could not take back British residents held at Guantanamo Bay, the Lord Chancellor said.
Speaking in Washington, Lord Falconer said the Government "could not legally deliver" on the terms for their release.
The deal reportedly came with the pre-condition that the prisoners were kept under 24-hour surveillance if set free in the UK.
Earlier this week, the Government came under increasing pressure to help set free the men, but said that as foreign nationals it was up to their governments to apply for their release from the controversial detention centre.
Liberal Democrat leader Sir Menzies Campbell said Britain had "a moral obligation" towards those held while Amnesty International called Britain's position "shameful".
Lord Falconer, who has previously described Guantanamo as a "shocking affront to the principles of democracy", repeated his attack.
In a speech at the Georgetown University Law Centre he stressed the importance of finding "the right balance between liberty and security in the modern world".
"But in seeking to strike that balance, if we say there are areas where the law doesn't reach, then we weaken ourselves and make finding that right balance all but impossible - because we would not be standing by our values," he said.
Terrorists needed to be starved of "perceived legitimacy", he said, adding: "Every time we fail to stand by our values we run the risk of acting as recruiting sergeants for terrorism."
In a clear reference to the reported deal over British residents he added: "I do not want to comment on the accuracy or otherwise of what has been reported.
"But what I can say is that it is important that we have a continuing dialogue with the US on these issues.
"And that it is obvious that we could not take people back into the UK on terms that we could not legally deliver."
Lord Falconer repeated the UK's position that Guantanamo should be closed, but welcomed the "strides forward" made by President Bush on the issue.
Details of a deal to free the British residents being turned down by the UK emerged in documents obtained by the Guardian.
The documents are under-stood to have been submitted by top Government officials for a judicial review into the decision, made by then Foreign Secretary Jack Straw, not to apply for the men's release.
The appeal, being heard at London's Royal Courts of Justice, was launched by the men's representatives and families and relates to nine men who are, or were, resident in the UK.