A judge had dismissed the case against PT Bumi Mekar Hijau (BMH), saying there was not enough evidence that the firm failed to prevent recurring fires.
Haze from forest fires in Indonesia affected South East Asia for months.
BMH supplies Asia Pulp and Paper, one of the world's biggest such companies.
The $565m in damages from the lawsuit would have been the largest financial reward ever levied against such a firm.
The government alleges BMH failed to prevent recurring fires in 2014 and this year on about 20,000 hectares of land in a region of Sumatra.
But presiding judge Parlas Nababan in a South Sumatra court said: "The lawsuit against PT Bumi Mekar Hijau is rejected because the evidence is not proven."
The director of law enforcement at the ministry of environment, Rasio Ridho Sani told the BBC the government is looking into its legal options now and companies must be held responsible for the fires in their areas even if they were not caused directly by the firm.
The forest and peatland fires, which caused dangerous levels of pollution in large parts of South East Asia in the second half of the year, were largely located on the islands of Sumatra and Borneo.

The families of six of the eight men who drafted the original 13 laws of Association Football were tracked down on behalf of the Football Association.
They have travelled from as far away as Washington DC, Chicago and Auckland, as well as Lancashire and London.
The event starts a week of celebrations to mark the FA's 150th birthday.
The FA said little was known about Ebenezer Morley, Arthur Pember, Charles William Alcock, Francis Maule Campbell, John Forster Alcock, Herbert Thomas Steward, George Twizell Wawn and James Turner, who formed the FA in 1863.
Mr Morley, a London solicitor who formed Barnes Football Club in 1862, wrote to popular newspaper Bell's Life suggesting that football should have one set of rules to end disputes about how the game should be played.
He said football should follow the example of cricket, whose rules were set by the Marylebone Cricket Club.
Mr Morley's letter led to the first meeting between the men at the Freemasons' Tavern in Great Queen Street, where the FA was formed on 26 October 1863.
Mr Morley was not represented as his family tree ended upon his death in 1924.
However, 16 relatives of six of the other men were expected to attend following a four-month search led by cultural historian Dr Jane Clayton, of the International Football Institute at the University of Central Lancashire.
It was also discovered that the family tree of Mr Pember crossed with that of another figure of huge historical and cultural significance, Charles Darwin.
In 1925 Mr Pember's great-niece married the evolutionary theorist's grandson, Charles Galton Darwin.
Dr Clayton said: "For the search to have been so successful is incredibly pleasing as, from a historical perspective, we now know a lot more about a number of the men that created the most popular sport in the world 150 years ago."
Alex Horne, general secretary of the FA, said: "In terms of historical significance, the eight founding fathers of football should be placed alongside other great pioneers of this nation.
"The game has become a focal point of the lives of nearly every household in England since it was formed, so to now understand more about the history of these men is incredibly important."
The Indonesian government has said it will appeal against a court decision that rejected a $565m (£381m) lawsuit against a plantation company accused of causing forest fires.
[NEXT_CONCEPT]
Descendants of the founding fathers of football have attended a ceremony at Wembley Stadium as a blue plaque was unveiled in their honour.