The Schwarzenegger administration lost a legal fight Friday to end oversight of California's prison health care system.
The 9th U.S. Circuit Court of Appeals ruled that a federal judge can continue with a court-appointed receiver to improve inmate medical care.
The appeals court also dismissed the administration's request to stop the receiver's construction plans to add medical beds.
California has been trying to end federal oversight of the state's prison system, largely because of the growing costs. The state is facing a projected $20 billion deficit through June 2011.
State officials argued the receiver in charge of making improvements had no right to order the construction of 10,000 new beds, which would cost about $6 billion.
The receiver has since responded with a more modest proposal to build two prison hospitals to house 3,400 inmates at a cost of $1.9 billion.
The appeals court upheld the district court's authority to appoint a receiver, saying it was the least intrusive way to remedy prisoners' rights.
The state did not oppose or appeal when the court appointed the receiver back in 2006 to improve care at the state's 33 adult prisons.
"We are compelled to point out that ... the state is in a poor position to assert this objection to the receivership," the three-judge panel wrote. "The receivership was imposed only after the state admitted its inability to comply with consent orders intended to remedy the constitutional violations in its prisons."