Jacky Rowland, Al Jazeera's Jerusalem correspondent, said the bill's rejection showed the government as a whole had not been behind the proposal.
"This committee within the Knesset [Israeli parliament] is responsible for examining draft laws that are being proposed, and they basically threw it out," she said.
"It was very clear that the Labor party, another important member of the coalition, wasn't having anything to do with this bill."
Labor said that the bill, which called for all citizens to take a pledge of allegiance, risked "creating the false impression" that Israel's Arab citizens were disloyal.
The pledge was a key element in Yisrael Beitenu's campaigning for the February general election, in which it came in third, winning 15 of the 120 seats in parliament.
The bill by Lieberman's secular nationalist party was aimed mostly at Israel's Arab citizens - some 20 per cent of Israel's population - and also at the ultra-Orthodox population.
Neither group does the military service, which is mandatory for most Israelis.
'Catastrophe' bill softened
A related bill on the Nakba, which many Palestinians lament as the "catastrophe" when they fled their homes in the wake of the 1948 creation of Israel, was watered down by the cabinet.
The revised draft law now prohibits any government funds from being used for events marking the Nakba, instead of banning commemorations altogether, a government official was quoted by the AFP news agency as saying.
"The original bill marked a serious infringement on the freedom of expression, which we deemed excessive," the official said.
The changes followed a legal review of the bill approved by the cabinet last week, which would have prohibited any events marking Nakba and provided for penalties of up to three years in prison.
US appeal rebuffed
In another development, Israel has refused to bow to US calls that it freeze settlement activity.
"I want to say in a crystal clear manner that the current Israeli government will not accept in any fashion that legal settlement activity be frozen," Yisrael Katz, Israel's transport minister and a close ally of Binyamin Netanyahu, said on Sunday.
Netanyahu did not address the issue at the opening of the weekly cabinet meeting, but the fighting words were echoed by other members of the cabinet, including the Labor party.
Several members of the Israeli cabinet belong to right-leaning or ultra-nationalist parties.