The ruling on Tuesday comes nearly nine years after aboriginal groups opened a human rights complaint against Ottawa over its funding formula for child welfare on reserves.
Prime Minister Justin Trudeau, who took office in November, has pledged to repair relations with Canada's 1.4 million indigenous people, who make up 5 percent of the population but represent about half of Canadian children aged 14 and under who live in foster care.
Aboriginals also have higher levels of poverty and a lower life expectancy than other Canadians, and are more often the victims of violent crime, addiction and incarceration.
The crisis on isolated reserves was highlighted last week by a school shooting in northern Saskatchewan. A 17-year-old boy has been charged in the deaths of four people.
The First Nations Child and Family Caring Society and the Assembly of First Nations, an umbrella group for Canada's largest indigenous group, charged that Ottawa was underfunding child welfare services on reserves compared with what is spent on non-native children or aboriginals living off reserve.
In its decision, the panel said Ottawa needed to make changes not only to its funding, but to the child welfare program itself "to respect human rights principles and sound social work practice."
"The panel acknowledges the suffering of those First Nations children and families who are or have been denied an equitable opportunity to remain together or to be reunited in a timely manner," the decision said.
The new Liberal government said it accepted the ruling and would make changes as soon as possible. Relations between aboriginals and the previous 10-year-old Conservative government had been strained.
"Frankly, my job is to go forward and fix these things and I am absolutely committed to doing it," Carolyn Bennett, Minister of Indigenous and Northern Affairs, told reporters.
A review previously commissioned by Ottawa found a child welfare funding shortfall on indigenous reserves of about 22 percent.
Ottawa is responsible for funding child welfare services for aboriginal children on reserves, including costs related to care of children removed from their parents' custody. Individual provinces fund child welfare services for non-native children and native children who do not live on reserves, creating a two-tiered funding system.