Assembly speaker Eileen Bell has ruled the assembly link between the UUP and the PUP breaks the assembly's rules.
The link between the PUP and UUP is against assembly rules
She said the Ulster Unionist Party Assembly Group did not have the characteristics of a party as laid down in the legislation governing parties.
However, the Ulster Unionist leader, Sir Reg Empey, criticised the speaker's ruling.
He said that he would continue to work with loyalists as they move toward peaceful politics.
"I have no intention of giving up my work and that of my party in trying to bring about the transformation to exclusively peaceful means in these areas that I believe is essential for stability and I will continue with that and I will redouble my efforts," he said.
Mr Ervine said the ruling "flew in the face of logic".
"You can tell me that I have to have forced coalition, but that within this building (Stormont) - which is supposed to be the epitome of democracy for Northern Ireland - we can't have voluntary coalition," he said.
Mrs Bell told assembly members that she had sought legal advice ahead of her decision.
She said the UUPAG, which was formed as a result of the alliance, did not have a headquarters, at least one party leader and a scheme for financial support.
The Ulster Unionists had came under widespread pressure after allowing PUP leader David Ervine to join their assembly group earlier this year.
The PUP is aligned with the loyalist paramilitary group the Ulster Volunteer Force.
At the weekend, an Ulster Unionist assembly member said he now believed the party's assembly alliance with the PUP was "untenable".
Assembly member Esmond Birnie said the section of the latest IMC report dealing with UVF activity was "grim".
He said it contained so many negatives that the link could not be maintained.
"I am someone who has said previously that the UUP pact with the PUP would always have to be conditional and subject to rigorous evaluation in the light of events.
"The litany of events over the last four months has been deeply disturbing," Mr Birnie said.
"As it stands at the moment I believe that this report renders the UUP's pact with the PUP untenable."
The party's only MP, Lady Hermon, had previously called for the link to be severed.
In June, the former Young Unionist chairman Peter Bowles left the UUP in protest at the link.
The Ulster Unionist leadership has said the assembly alliance with the PUP does not represent an arrangement with the UVF.
The move was aimed at giving them an extra ministerial seat at Sinn Fein's expense if a power-sharing executive is formed.
Party leader Sir Reg Empey has said the long-term goal of the link was to end loyalist paramilitarism.
The deputy leader of the DUP, Peter Robinson, said that the ruling meant that the UUP had been split by the issue, but would gain no advantage in assembly seats.
"I think this is a nightmare of a ruling for the Ulster Unionist Party, when Reg thinks things couldn't possibly get worse they do," he said.