Mr Lee, a former mayor of Seoul and construction executive, had sought to overturn a proposal drawn up by his liberal predecessor to move a dozen government ministries and agencies to a new city, Sejong, 95 miles to the south.
The prospective city is named in honour of the Joseon Dynasty king, Sejong the Great, the father of Korea's national alphabet.
Mr Lee has criticised the move as "pork-barrel politics" and a waste of taxpayers' money, and proposed as an alternative a plan to turn Sejong into a research and development hub.
The issue has hijacked the legislative agenda, hindering the passage of Mr Lee's pro-business reforms.
The president's Grand National Party (GNP) has a solid majority in parliament. But a large party faction led by the popular daughter of an assassinated former president has come out against Mr Lee on Sejong City, putting at risk its ability to pass legislation.
The rival, Park Geun-hyee, is a strong contender to succeed Mr Lee as president when his single five-year term expires, and she has sided with the opposition in pushing for the original plan, saying it was a promise to voters that must be kept.
After his party's drubbing in local elections this month, Mr Lee pressed parliament to put the move to a vote, to snuff out an initiative that never gained traction even with his own allies and may have dented his party's popularity.
Yesterday, a parliamentary committee rejected his proposal, by 18 votes to 12, with one abstention.
The GNP hopes to bring it back up for a vote next week before the full session of parliament, but analysts expect that it will be defeated there, too.
"This effectively means the end of any attempt to change the (capital move] plan," said political analyst Yu Chang-seon.
"I can't see anyone on the horizon who would try to take it up again."
Critics have denounced the administrative city plan as a white elephant, while supporters claim it would help promote the cause of regional development and ease congestion in Seoul.