The chief prosecutor of the Court of Appeal had accused the party of using religion for political goals and steering Turkey's secular system toward Islamic rule based on Sharia law.
Six of the 11 judges voted in favor of closing down the Justice and Development (AK) Party, falling just one vote short of the seven required to rule in favor of the prosecution.
The AK Party, which first came to power in November 2002, received around 47% of the vote in a parliamentary election last July and was allocated 341 seats in the 550-seat parliament.
The case against the party was first brought to court in March.
Chief prosecutor Abdurrahman Yalcinkaya demanded that 71 party members, including Erdogan and President Abdullah Gul should be banned from politics for five years for mixing Islam and politics.
The key argument of the chief prosecutor was that Erdogan's party sponsored a constitutional amendment in February aiming to abolish a ban on the Islamic headscarf in state universities.
The headscarf issue is a source of tension in predominantly Muslim Turkey. Almost two-thirds of Turkish women wear the headscarf and many of them stopped attending universities after the traditional Islamic covering was banned on campuses in 1989.
The controversial bill, seen as the symbol of political Islam, which is a sensitive issue in Turkey, was vetoed in June on the grounds that it contravened the principles of secularism written into the country's constitution.
The Turkish opposition had suggested that through such legislation the ruling Justice and Development Party was seeking to increase the role of Islam in the traditionally secular Turkish state and that other bills - to lift similar bans in high schools and government offices - would follow.
