By Jonathan Stempel

NEW YORK (Reuters) - A U.S. appeals court on Wednesday threw out a $655.5 million verdict against the Palestinian Authority and the Palestine Liberation Organization for damages suffered by American families from terrorist attacks in Israel.

By a 3-0 vote, the 2nd U.S. Circuit Court of Appeals in Manhattan said a lower court judge erred in concluding he had jurisdiction over the case. The appeals court ordered that the civil lawsuit, which began in January 2004, be dismissed.

"The terror machine gun attacks and suicide bombings that triggered this suit and victimized these plaintiffs were unquestionably horrific," Judge John Koeltl wrote for the appeals court.

"But the federal courts cannot exercise jurisdiction in a civil case beyond the limits prescribed by the due process clause of the Constitution, no matter how horrendous the underlying attacks or morally compelling the plaintiffs' claims."

Wednesday's decision is the latest setback for efforts to hold foreign entities liable in U.S. courts for damages related to terrorism.

The 10 families who had won the verdict had sued under the Anti-Terrorism Act, which lets American victims of international terrorism sue in U.S. courts.

"The very terrorists who prompted the law have now hidden behind the U.S. Constitution to avoid responsibility for their crimes," Kent Yalowitz, a lawyer for the families, said in an email. "This cruel decision must be corrected so that these families may receive justice."

Yalowitz said Congress and the State Department should intervene to ensure the families are compensated.

"This is a Palestinian victory that should not be underestimated and it is a big blow to anyone who attempts to blackmail us," Palestinian Finance Minister Shukri Bishara said in an interview. "We have drawn a red line under it."

Gassan Baloul, a lawyer for the defendants, said in an email they were gratified with the court's findings on jurisdiction.

SIX ATTACKS

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The families had sought to hold the Palestinian Authority and PLO liable for six shootings and bombings between 2002 and 2004 in the Jerusalem area. The attacks killed 33 people, including several Americans, and wounded more than 450. They have been attributed to the al-Aqsa Martyrs Brigades and Hamas.

The families said late PLO Chairman Yasser Arafat and his agents routinely arranged for payments to attackers and to families of attackers who died. But the defendants have said they condemned the attacks and blamed them on rogue employees who acted on their own.

In February 2015, after a six-week trial, a federal jury in Manhattan awarded the families $218.5 million, which was tripled automatically to $655.5 million under the Anti-Terrorism Act.

The appeals court said the trial judge, George Daniels, erred in letting the case proceed at all.

Koeltl said the attacks occurred "entirely outside" U.S. territory, and found no evidence that Americans were targeted.

He also said that while the Palestinian groups maintained a mission in Washington, D.C., and promoted their cause within the country, this did not make them "essentially at home" in the United States.

Last August, without taking a position in the case, the U.S. government said it strongly supported the right of terrorism victims to pursue damages in federal court. It nonetheless told Daniels that requiring the defendants to post a high bond during their appeal could impede their operations and further destabilize the region.

OTHER LEGAL SETBACKS

Wednesday's decision is the second in eight days by the Manhattan appeals court against victims of attacks in Israel.

On Aug. 24, the court said it lacked jurisdiction to hold Lebanese Canadian Bank SAL liable under the Alien Tort Statute to victims of Hezbollah rocket attacks, for allegedly helping finance that group through a New York bank account.

In December, the court said thousands of non-U.S. citizens could not sue Jordan's Arab Bank Plc for allegedly providing support to Hamas, al-Aqsa and others for attacks in Israel.

Arab Bank settled separate litigation under the Anti-Terrorism Act last August over its responsibility for attacks in Israel. That accord is conditioned on an appeal of a Brooklyn jury's underlying liability verdict from 2014.

The case is Sokolow et al v. Palestine Liberation Organization et al, 2nd U.S. Circuit Court of Appeals, No. 15-3135.

(Reporting by Jonathan Stempel in New York; Additional reporting by Ali Sawafta in Ramallah; Editing by Bill Trott)