The Planning Assessment Commission (PAC) has advised against allowing Apex Energy to drill 16 exploration CSG wells in the Illawarra/Wollongong area, south of Sydney.
The local community - which has been fighting the project since Apex was first granted approval for 15 wells in 2009 - has claimed it as a "huge win" in the battle to protect Sydney's drinking water.
"But we are celebrating winning a battle, not the war," said Stop CSG spokeswoman Jess Moore.
"The campaign to have O'Farrell keep his promise and ban CSG development in drinking water catchments will continue."
In its report published on Wednesday, the PAC pointed out the CSG industry was relatively new to NSW and currently operated at only a handful of sites.
It also stated that the impacts of CSG activities were being questioned in a range of studies in NSW, Australia and internationally.
"It appears that the potential risks of coal seam gas activities are still being established and there is some uncertainty regarding the potential impacts," the report said.
It said that until conclusive findings could be made it would be inappropriate to approve any coal seam gas activities in special areas of the Sydney water catchment.
The PAC also advised waiting for NSW Chief Scientist and Engineer, Mary O'Kane, to complete her review into all coal seam gas activity in NSW, including the effect on groundwater and drinking water.
NSW Premier Barry O'Farrell announced the review in February. He also announced a ban on all CSG activity within 2km of residential areas.
The PAC report said it expected Ms O'Kane's report "will take some time to complete".
Greens MP Jeremy Buckingham said the idea of drilling and fracking in Sydney's drinking water catchment area was "always ludicrous".
"This PAC decision is a victory for common sense," he said.
"Sydney's drinking catchment should be protected from a toxic heavy industry like coal seam gas."
Mr Buckingham called on the O'Farrell government to ban CSG exploration permanently.
"Prior to the last election, Barry O'Farrell promised to end mining and exploration in water catchments - no ifs, no buts, a guarantee," he said.
Comment was being sought from the NSW government.
