Treasury Board violated the Public Service Labour Relations Act by imposing conditions in advance on binding arbitration, the ruling stated.
But in its 27-page decision, the board does not impose a remedy in the long-running saga that universities and tourism groups say has deprived foreign students and travellers from getting the visas they need to come to Canada.
The decision urges Treasury Board and the 1,350-member Professional Association of Foreign Service Officers to go back to bargaining to break the impasse.
"I conclude that the respondent engaged in bad faith bargaining in its approach," the ruling stated.
"I do not believe that it is conducive to good labour relations to order parties to participate in final and binding determination when such arbitration is voluntary in the first place," it added.
"I encourage the parties to be guided by my comments in this decision and to renew their attempts at arriving at mutually agreeable conditions."
The union asked Treasury Board in July to consent to binding arbitration.
Treasury Board President Tony Clement agreed but then insisted on a series of preconditions, including taking the union's key demand for wage parity off the table.
The foreign service staff want wage parity with their counterparts in other federal departments, who they say make as much as $14,000 more doing similar work.
"It was an impossibility for the complainant to put forward its argument concerning wage parity, which it held throughout the negotiation process," Friday's ruling said.
"The respondent's conditions required the complainant to abandon the position it's held throughout the negotiations."
Therefore, the process of going into arbitration "would be moot," the ruling stated.
The union said Friday it was waiting for Treasury Board to return to the negotiations with a revised offer.
"The time has come for the government to change tack," union president Tim Edwards said in a statement.
"Our offer to take this dispute to binding arbitration without paralyzing preconditions still stands."
Treasury Board had yet to issue a statement as of Friday afternoon.
The union which has been without a contract since mid-2011, has been staging rotating walkouts at more than a dozen foreign missions. It has targeted the foreign travel of cabinet ministers and the processing of visas for potential visitors to Canada.
NDP foreign affairs critic Paul Dewar urged the government to get back to the table and bargain in good faith.
"The Conservative government's bad faith handling of the labour dispute with Canada's diplomats is hurting the country's economy and our image abroad. It has hurt our communities and undermined the important work of our diplomats," Dewar said in a statement.
"Instead of trying to discredit our diplomats, I call on Tony Clement to get back to the negotiation table and resolve this dispute through good faith bargaining."