The Communications Data Bill would force telecoms service providers to retain for a year records of all phone and email traffic and website visits, though not the content of calls and messages.
The data on billions of emails, tweets, texts, calls and Internet hits would be available to police forces, the National Crime Agency and the revenue and customs service. The bill as it stands gives the government the power to extend that access to other agencies.
Home Secretary Theresa May has called the proposals "sensible and limited" measures to prevent crime and terrorism.
But an all-party parliamentary committee scrutinizing the legislation said the draft bill was "overkill and ... much wider than the specific needs identified by the law enforcement agencies."
The committee said the bill would give the home secretary Britain's interior minister powers to order communications companies to disclose "potentially limitless categories of data."
"There is a fine but crucial line between allowing our law enforcement and security agencies' access to the information they need to protect the country, and allowing our citizens to go about their daily business without a fear, however unjustified, that the state is monitoring their every move," said the committee's chair, Conservative peer David Maclean.
The proposals have split Britain's coalition government, which contains both law-and-order minded Conservatives and members of the Liberal Democrats, who campaigned on a promise to curb government intrusion and protect civil liberties.
Deputy Prime Minister Nick Clegg, leader of the Liberal Democrats, said the law required a "fundamental rethink."
"We cannot proceed with this bill and we have to go back to the drawing board," he said.
Security Minister James Brokenshire, a Conservative, said the government would amend the legislation in an attempt to get it through Parliament.
"We know that there is work that needs to be done and I absolutely accept that," he told BBC radio.