"The United States is very disappointed with the outcome of this dispute," Nkenge Harmon, a spokeswoman for the U.S. Trade Representative's Office, said. "The ban on cigarettes with flavors is part of landmark U.S. legislation to combat the public health crisis caused by tobacco products."

Indonesia, the world's top producer of clove cigarettes and the source of the vast majority of those smoked in the United States, brought the World Trade Organization case in April 2010.

The U.S. Congress passed legislation during President Barack Obama's first year in office in 2009 banning the production and sale of cigarettes with flavors such as clove, cinnamon, strawberry or cherry, but not regular or menthol cigarettes.

The WTO appellate body on Wednesday said the ban on clove cigarettes was discriminatory because a similar product, menthol cigarettes, can still be sold in the United States.

Matthew Myers, president of Campaign for Tobacco-Free Kids, said the WTO "wrongly concluded that a decision by the U.S. Congress on how best to protect America's children from flavored cigarettes that serve as starter products for youth violates the nation's trade obligations."

A California Democrat who played a leading role in passage of the Family Smoking Prevention and Tobacco Control Act, said the decision had "serious public health implications" for U.S. efforts to reduce teen smoking, but vowed the clove cigarette ban would remain.

"I believe the WTO's interpretation is wrong on the merits and wrong in its interference with our efforts to protect the American public from tobacco's devastating effects," Representative Henry Waxman said, noting the U.S. law does not distinguish where cigarettes are made.

Harmon said the U.S. Trade Representative's Office was examining its options for complying with the ruling.

If the ban remains, Indonesia could impose retaliatory duties on the U.S. exports equal to the amount of trade it has lost, which one analyst estimated at about $16 million per year.

The United States could also comply by offering Indonesia new trade concessions, as it has done in some other disputes where Congress was unwilling to change the law.

Myers urged the Food and Drug Administration to ban menthol cigarettes, noting a scientific advisory committee created by the 2009 law had recommended that more than a year ago.

"The FDA has had more than enough time to determine how to implement the committee's recommendation," Myers said. "It is time for the FDA to act."

That would affect cigarette makers Lorillard Inc, the Philip Morris USA unit of Altria Group, the R.J. Reynolds Tobacco Co. unit of Reynolds American Inc, and Liggett Vector Brands LLC.

Mark McMinimy, a senior policy analyst with Guggenheim Securities, said in a research note that he doubted the Obama administration would take that step.

U.S. trade officials made "forceful arguments" against a ban on menthol cigarettes in their WTO appeal, he said.

It is unlikely the FDA would ban or phase out menthol cigarettes without "the emergence of new and compelling information that indicts this product as a special menace to public health," McMinimy said.

(Reporting by Tom Miles and Doug Palmer; Editing by John Stonestreet and Jackie Frank)

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