A planned multi-million-dollar revamp of Melbourne's historic Forum Theatre, which included a 32-storey hotel, is in doubt after a permit was overturned by Victoria's planning umpire.

The restoration of the 85-year-old theatre, on the corner of Flinders and Russell Streets, included a boutique hotel with office and retail space at the back of the building with a pedestrian link to Hosier Lane.

Former planning minister and now Opposition Leader Matthew Guy granted the permit to the Marriner Group to build the 32-storey site.

But the City of Melbourne opposed the plan citing concerns about heritage, design and height, and the impact on street art on Hosier Lane.

The council took the matter to the Victorian Civil and Administrative Tribunal (VCAT), which found Mr Guy did not have the power to bundle the Forum restoration and the hotel projects together.

Mr Guy told 774 ABC Melbourne he had acted on advice from his own department when he granted the permit.

"It's another example of a hit-and-miss VCAT decision, but it is what it is," he said.

"I took the advice when I was the minister of the department.

"The department gave me advice to deal with it as one permit, and I did, and it gave me advice to approve it, and I did."

Mr Guy said the ruling highlighted the need to "reign in" VCAT.

"The Government will need to provide it with a greater level of definition as to how it works within the planning system," he said.

Construction work was due to start on the development early this year.

A group opposed to the project, called Keep Hosier Real, claimed the project would ruin the Forum and the famous street art precinct around Hosier Lane.

In response to the VCAT decision, it said on Facebook: "We are over the moon! Thanks for all your support. What an amazing community we have."

When the plan was announced Mr Guy said 99 per cent of Hosier Lane would remain untouched.