New Zealand retailers are responsible for the correct fire safety labels on garments and face fines of up to $200,000 for every breach of the Fair Trading Act.
A Commerce Commission spokeswoman said there were no customer complaints about the Cotton On garments in New Zealand and "as the product had been removed from the shelves here, the commission's view was that the safety issue had been resolved satisfactorily".
Australian authorities saw it differently and pursued Cotton On for the record million-dollar breach.
The Federal Court of Australia this week ruled the potential consequences of Cotton On's blunder were "most serious" and called for "a significant penalty".
The judge noted the garments were intended to be worn by infants and children, "who were a significantly vulnerable class of consumers".
At least 2500 unsafe children's nightdresses and pyjamas were sold in Australia between September and December 2010.
The garments were available for three months longer in New Zealand.
The voluntary recall was made in both countries in April last year after Cotton On was approached by the Australian Competition and Consumer Commission (ACCC).
A Cotton On spokeswoman said the company had worked "diligently to address the concerns raised".
She said Cotton On took "the safety of our products very seriously", despite the court finding that the pyjamas were inherently dangerous.
Cotton On's own New Zealand recall notice warned the garments posed "a serious safety risk" to children because of their flammability.
The company said that since the pyjamas blunder it had further invested in its team to monitor "the safety and compliance of our products".
"We have also engaged independent testing agencies to test all children's sleepwear," the spokeswoman said.
The fines against Cotton On in Australia comprised of A$400,000 each for the non-compliance with standards of nightdresses and pyjamas and A$100,000 each for misrepresentations made on the labels of the two types of garments.
The ACCC said it was the highest penalty imposed on a company for breaches of mandatory product safety standards.
ACCC deputy chairwoman Delia Rickard said the decision sent "a strong message".
"These breaches were very serious as they placed the safety of young children at risk," she said.
"This case demonstrates that failure to comply with mandatory safety requirements can see a supplier end up in court and exposed to substantial penalties."
All children's nightwear sold in New Zealand must carry a fire hazard label.
The Commerce Commission says although a manufacturer is likely to test and label children's nightwear they supply, it is the company selling the clothing that is responsible for making sure it carries the correct fire danger labels.
