Arizona was one of two states that refused to issue licenses to the immigrants, sparking the latest court fight over the issue.
Republican Gov. Jan Brewer called the ruling misguided and said she was considering appeal.
The decision follows other high-profile battles between Arizona and the federal government over immigration, including court decisions that struck down much of a 2010 enforcement law but upheld its most hotly debated section, which requires police to check immigration status under certain circumstances.
"We hope that this ruling signals the end of what has been an unfortunate anti-immigrant period in Arizona," said Karen Tumlin, one of the attorneys representing the immigrants.
A three-judge panel of the 9th U.S. Circuit Court of Appeals found there was no legitimate state interest in treating young immigrants granted deferred action on deportation differently from other noncitizens who could apply for driver's licenses. Instead, the panel suggested the policy was intended to express hostility toward the young immigrants, in part because of the federal government's policy toward them.
The decision should remove any barriers young immigrants face in getting a driver's license in Arizona, Tumlin said.
The ruling comes during a national focus on the topic as tens of thousands of immigrants from Central America - many unaccompanied children - have illegally entered the country in recent months, straining the capacity of detention centers along the U.S.-Mexico border.
The Obama administration in June 2012 took administrative steps to shield thousands of immigrants from deportation and expand their legal rights. The move assists immigrants younger than 30 who came to the U.S. before turning 16, have been in the country for at least five continuous years, are enrolled in or have graduated from a high school or GED program or have served in the military. Aside allowing driver's licenses, applicants also were allowed to pursue a two-year renewable work permit.
About 520,000 people have been approved to take part in the program, including about 19,000 in Arizona.
Brewer issued an executive order in August 2012 directing state agencies to deny driver's licenses and other public benefits to young immigrants who get work authorization under the program.
She pointed out Monday that the judges who ruled against her were appointed by Democratic presidents. She blames Obama's policy for the recent influx of immigrants entering the country illegally and notes that the program isn't federal law. "Lawless decrees by the president demonstrate animus to Congress, states and the Constitution," Brewer said.
The appeals panel ordered a lower court judge to issue a preliminary injunction blocking Brewer's executive order while the case is litigated. It's unknown how long it will take for the case to conclude.
Brewer's attorneys said the decision to deny driver's licenses grew out of liability concerns and the desire to reduce the risk of the licenses being used to improperly access public benefits.
Brewer's refusal marked the nation's most visible challenge to the Obama policy on young immigrants.
Nebraska is the only other state to have made similar denials, and a federal judge this year dismissed a lawsuit contesting the state's policy.