The federal court found that legal protection and redress in cases such as Arar's should be determined by the US congress and not the courts.
"Once congress has performed this task, then the courts in a proper case will be able to review the statute and provide judicial oversight," the ruling said.
But Judge Guido Calabresi, who voted in favour of Arar being able to sue, wrote: "I believe that when the history of this distinguished court is written, today's majority decision will be viewed with dismay."
Arar said in a statement that the ruling proves "the court system in the United States has become more or less a tool that the executive branch can easily manipulate through unfounded allegations and fear-mongering."
The Center for Constitutional Rights, which represented Arar, did not say whether it would appeal against the ruling to the US supreme court.
When Arar filed his lawsuit against US officials in 2004 it marked the occasion where an individual challenged the US government's policy of "extraordinary rendition" - a process where suspects are sent to a third country where there are no restictions on the use of torture during interrogation.
"It's the court's role to uphold the law and the law prohibits torture and provides for redress," Maria LaHood, an attorney for the Center for Constitutional Rights, said.
"Torture is universally agreed to be illegal and unconstitutional."
The Canadian government formally apologised to Arar in 2007 and paid him a $9.8m settlement.
Condoleezza Rice, a former US secretary of state, admitted that the US made mistakes in the handling of Arar's case but she did not apologise.