By David Shepardson

WASHINGTON (Reuters) - A federal appeals court said on Wednesday the U.S. Federal Communications Commission could not block two states from setting limits on municipal broadband expansion, a decision seen as a win for private-sector providers of broadband internet and a setback for FCC Chairman Tom Wheeler.

Cities in Tennessee and North Carolina had sought to expand municipal broadband networks beyond current boundaries, but faced laws forbidding or placing onerous restrictions on the expansions.

The FCC voted 3-2 in 2015 to issue an order seeking to pre-empt those state laws, saying a 1996 law required it to remove barriers to broadband investment and that the municipalities wanted to expand service into areas with little or no internet service.

Wheeler criticized the decision that "appears to halt the promise of jobs, investment and opportunity that community broadband has provided in Tennessee and North Carolina."

He said since 2015, "over 50 communities have taken steps to build their own bridges across the digital divide. The efforts of communities wanting better broadband should not be thwarted by the political power of those who, by protecting their monopoly, have failed to deliver acceptable service at an acceptable price."

Republican FCC Commissioner Ajit Pai said that "rather than wasting its time on illegal efforts to intrude on the prerogatives of state governments, the FCC should focus on implementing a broadband deployment agenda to eliminate regulatory barriers that discourage those in the private sector from deploying and upgrading next-generation networks."

USTelecom, the trade group that represents internet service providers including AT&T and Verizon Communications Inc, praised the decision as "a victory for the rule of law."

The group said the FCC should "concentrate on eliminating federal regulatory impediments to innovation and investment - where there remains to be much that can and should be done."

The city of Chattanooga, Tennessee's municipal electricity provider since 2009, has offered high-speed broadband internet service to residential and commercial customers in its 600-square-mile service area. About 63,000 subscribe to the service. Residents in neighboring communities have asked to use the service.

Wilson, North Carolina in 2005 constructed the backbone of a fiber-optic network connecting all city-owned facilities that was expanded to a municipal broadband network now known as "Greenlight."

The city offers phone, internet and cable services which it says are cheaper than its private-sector competitors. The city also provides free Wi-Fi service to its entire downtown area and each of the top seven employers in Wilson is a customer. Individuals in five neighboring counties have also sought to join.

The FCC has noted that companies in Tennessee, including Inc and Volkswagen AG, use the service in Chattanooga.