Government has baulked at making changes to the supply of "cheap" raw milk to Fonterra's rivals - which would have raised retail prices - in advance of the coming general election.
" The time is not right for increases in the price of milk and dairy products for domestic consumers," said Agriculture Minister Jim Anderton.
"In the current economic environment, it is not responsible to take decisions that could increase the price of milk for domestic consumers next year."
Instead, the Government has rolled over for another dairy season a formula that sets the price of "regulated milk", and told Fonterra to keep supplying 600 million litres for next season.
Fonterra controls about 95 per cent of the nation's milk production, which is about 15 billion litres a year, and was initially required by law to provide smaller companies with 400 million litres a year at cost price.
Its main rival, Goodman Fielder, gets 250 million litres for its Meadowlea brands, and other independents can each seek up to 50 million litres.
But the 400 million litres allocation has proved too low and last season the Government boosted the amount to 500 million, then 600 million for this season.
Today Anderton said the Government would introduce legislation to force Fonterra's rivals to bid for the milk at an auction after the 2010 season, and pay a premium.
The present default price is set by a formula laid down during Fonterra's mega-merger.
A government review ordered last year sided with Fonterra's claim that the formula for setting the default price resulted in independent processors accessing milk at a lower cost than Fonterra. And it found no mechanism in the regulations to manage excess demand for regulated milk by independent processors.
"If the default pricing formula was kept beyond next season it would create a real risk of processors making investment decisions that are economically unsustainable," said Anderton. "An auction is a fair way of setting prices."
The Commerce Commission, which oversees the Dairy Industry Restructuring Act, recommended regulated milk should be increased to 5 per cent of Fonterra's supply - about 750 million litres - the maximum allowed in the Act.
The commission also recommended a review of sunset clauses which require Fonterra to supply regulated milk until the production of its rivals hits specific trigger levels, which will abruptly end the obligation as early as 2013.
The Commerce Commission proposed Fonterra be compelled to provide significantly greater quantities of regulated milk indefinitely, but Anderton said an auction was the best way to manage the transition risks identified by the commission.
"Introduction of an auction from the 2010/11 season will remove uncertainty for Fonterra, independent producers and for farmers," he said. By 2011 the domestic wholesale price of milk is likely to fall relative to this year's price.
Anderton guaranteed small independent processors guaranteed supply at no more than the "average" auction price.
He rejected creating a two-tier pricing system so that independent processors with their own milk supply paid a higher "exporter" price, while small-scale processors and those without their own supply, such as Goodman Fielder, continued to pay the "low" default price.
The Government could also have set a higher "farmgate" price for milk next year, before moving to an auction system, but did not want even a potential increase in domestic dairy prices.
A further rejected option would have managed excess demand by imposing time limits on big processors with their own supply.