Consumer Reports said its tests show a hardware defect causes the iPhone 4 to lose reception when held a certain way, challenging Apple Inc.'s claims that the problem is rooted in software that can be easily fixed.

The product-quality watchdog said Monday it can't recommend the newest iPhone despite otherwise high marks, dinging a company that for many shoppers can do no wrong. It was the first time Consumer Reports has failed to give the thumbs up for an Apple phone.

Apple...