The Neighbourhood Nurseries initiative gave Cumbrian children's centre Jumping Jacks the money last year, as part of an 8m nationwide move by ministers to provide affordable nurseries in disadvantaged areas.
But Ofsted halted the scheme just three weeks before it was due to offer 35-a-night supervision for under-14s.
Ofsted said the centre had to register as a children's home, which would mean retraining childcare-qualified staff as social workers and spending an extra 10,000 a year on insurance.
Jumping Jacks' owner Jane Crawford now plans to lobby for a change of law to make round-the-clock childcare easier.
"I consulted Ofsted and the Department for Education and Skills, and they said they would register us," said Crawford. "Now they are saying they have changed their minds.
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