Tiscali Juke Box, which launched in April, was a legal peer-to-peer service where songs could be listened to but not copied or downloaded, and royalties were paid for "non-interactive rights" to songs.
However the IFPI decided Tiscali "was paying to offer one type of service but was actually offering another very different one".
"Consumers were allowed a high degree of interactivity that breached these rules in many ways - for example, streaming individual tracks on demand," it said.
The IFPI said it was happy to facilitate discussions between Tiscali and record labels on the possibility of licensing "interactive rights".
"In the meantime Tiscali will have to operate under the terms of its agreement or continue to suspend its service," it said.
'Short-sighted'
Tiscali.co.uk editor Richard Ayers said: "It's very disappointing.
"We were trying to develop a new and innovative service in order to increase the appreciation of music, and indeed the purchasing of music. It was clearly working."
He said there had been a 30% rise in purchases from Tiscali Music Club since it launched Juke Box.
He added that Mercora, which was a partner in the Juke Box service, had been running the same service in the US for more than a year.
"I don't quite understand why the European record labels appear to have a problem, whereas the ones in the US don't."
A Tiscali statement accused the industry of "short-sightedness... in not making any effort to understand either the basic needs or habits of music fans that choose to consume music via the internet, or the acts directly benefiting from this promotion".
It also said: "The industry's conservative attitude makes any collaboration for the promotion and marketing of any type of legal, innovative service very difficult."
