The High Election Board ruled that a fresh Istanbul mayoral contest will be held on June 23. The AK Party representative on the board, Recep Ozel, said the decision was based on unsigned results documents from the March 31 election and on some ballot box officials not being civil servants.
Turkey's main opposition Republican People's Party (CHP), which narrowly won the mayor's office in the country's largest city, called the ruling a "plain dictatorship."
Kati Piri, the European Parliament's Turkey rapporteur, said the decision "ends the credibility of democratic transition of power through elections" in the country.
Reuters witnesses said people were banging on pots and pans in protest against the ruling in several Istanbul districts.
The AKP had appealed for an election re-run after initial results and a series of recounts showed it had lost control of Istanbul for the first time in 25 years.
It was a shock loss for Erdogan, who in the 1990s served as the city's mayor and had campaigned hard ahead of the nationwide local vote, his first electoral test since last year's sharp currency crisis tipped the Turkish economy into recession.
The Turkish lira weakened and was at 6.1075 against the dollar at 1730 GMT, on track for its worst day in more than a month.
The currency has tumbled more than 10 percent since a week before the initial election. Suspense over the ruling had left investors worried that weeks of additional campaigning would divert funds and attention from addressing economic reforms.
"This is damaging for Turkey's perception as a democracy and will leave Turkey's economy vulnerable, given risks to macro financial stability in the period to July," said Timothy Ash of Blue Bay Asset Management.
Inflation near 20 percent and unemployment near 15 percent drove many voters to abandon the AKP in the initial vote. Before the second vote, tensions with the United States could escalate over Turkey's planned purchase of a Russian S-400 missile defense system, which could trigger U.S. sanctions.
IRREGULARITIES
It was unclear how the CHP and its supporters would respond to a re-run given suspicions over the YSK's political independence from the AKP, which in recent years has centralized power in the presidency away from other institutions.
One CHP member of parliament, Mehmet Bekaroglu, said on Arti TV that the AKP pressured and threatened YSK judges with prison if they voted against a re-run. Piri of the European Parliament also said pressure was applied to re-do the elections.
"It is illegal to win against the AK Party," CHP Deputy Chairman Onursal Adiguzel said on Twitter. "This system that overrules the will of the people and disregards the law is neither democratic, nor legitimate."
In the capital Ankara - where the AKP also lost the mayor's office to the CHP - police blocked the entrance to the YSK's headquarters on Monday evening. The YSK also ruled to file a criminal complaint against those district election board officials who had appointed the ballot box officials.
With its nationalist MHP allies, the AKP wanted the Istanbul results annulled and cited irregularities that affected the outcome, which put it some 13,000 votes behind CHP. On Saturday Erdogan said "it's clear" the vote was marred by controversy and urged the YSK to "clear its name" with a re-run.
Ekrem Imamoglu, the CHP mayor who officially took office after a smattering of recounts were completed across Istanbul last month, condemned the YSK for annuling the results under AKP pressure.
"Shame on the YSK. They were placed under political pressure from day one," Imamoglu told hundreds of chanting and flag-waving supporters.
Turkey held a re-run of general elections in 2015 when the AK Party failed for the first time since its founding to form a single-party government. In a repeat election, AK Party found the support to form it again.
In recent weeks city prosecutors began probes into alleged irregularities and called 100 polling station workers in for questioning as suspects.