The decision by a divided three-judge panel in San Francisco reinstated a lawsuit filed against the video sharing website by an actress who appeared in the video.
The 14-minute film, Innocence of Muslims, depicts the prophet Mohammed as a religious fraud, paedophile and womaniser.
It enraged Muslims around the world and sparked violence in late 2012.
At the time, YouTube rebuffed requests from President Barack Obama to take it down, arguing that only the filmmaker and not the actress owned the copyright.
Four Americans, including Ambassador Chris Stevens were killed in the September 11, 2012 attack.
Wednesday's ruling by the 9th Circuit Court of Appeals, however, dealt with control of the film, not its contents, which YouTube determined did not violate its standards.
The court said the YouTube posting infringed actress Cindy Garcia's copyright to her role, and she, not just the filmmaker, could demand its removal.
Ms Garcia said she was duped into appearing in the film by the man behind it, Mark Basseley Youssef.
She said the script she saw referenced neither Muslims nor Mohammad, and her voice was dubbed over after filming.
The court said the actress owned the copyright to her performance because she thought it was for another film unrelated to what ultimately aired.
Youssef was sentenced to a year in California prison in November 2012 for violating probation stemming from a 2010 bank fraud conviction.

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