The decision to refuse compensation was "defective and contrary to natural justice", according to Ian Glen QC, who was representing Barry George.
Despite Mr George's unanimous acquittal by a jury at his retrial, a Ministry of Justice "functionary" had unfairly and unlawfully decided he was "not innocent enough to be compensated".
Mr Glen said that for more than 30 years those acquitted on retrials in similar circumstances had been compensated.
He said: "We are not sure when the policy was changed or whether it was affected by the Barry George case."
The position seemed to have changed in 2008, the year Mr George was acquitted, Mr Glen added.