The law, passed in 2002, is believed to have kept hundreds, and possibly thousands, of Palestinians from moving to Israel to live with their families.
An expanded panel of 11 judges voted 6-5 on Sunday against a petition to strike it down.
Muad el-Sana, an Israeli-Arab lawyer who is married to a Palestinian woman from the West Bank town of Bethlehem, said: "This is a very black day for the state of Israel and also a black day for my family and for the other families who are suffering like us.
"The government is preventing people from conducting a normal family life just because of their nationality," el-Sana told Israel Radio, minutes after the ruling was announced.
The government has repeatedly said the law was based on security concerns, but the restrictions also cut to a more sensitive demographic issue - the fear that the country's Jewish majority could be threatened if too many Palestinians are granted citizenship.
Critics of the law say it is racist and discriminatory. Amnesty International called on Israel to repeal the law, calling it "explicitly discriminatory".
Politician Zehava Galon, of the Meretz party, told Israel Radio: "I had hoped and expected the high court to be the last arena for protecting democracy.
"In essence we are talking about a means to halt the demographic threat. There are no real security issues."
Orna Kohn, an lawyer from Adalah, a group that fights for the rights of Israeli-Arabs, said the court's ruling causes "grave damage to the basic rights of thousands of people".
"I am afraid the message the Supreme Court relayed today will allow additional racist legislation," she told Israel Radio.
The court had granted el-Sana's wife a temporary injunction preventing her deportation. But el-Sana said the high court's ruling made it almost impossible for them and their two children, aged two and five months, to live together.