A court in Hamburg ruled that YouTube is responsible for the content that users post to the video sharing site.
It wants the video site to install filters that spot when users try to post music clips whose rights are held by royalty collection group, Gema.
The German industry group said in court that YouTube had not done enough to stop copyrighted clips being posted.
YouTube said it took no responsibility for what users did, but responded when told of copyright violations.
“Today’s ruling confirms that YouTube as a hosting platform cannot be obliged to control the content of all videos uploaded to the site,” said a spokesperson for the video site.
“We remain committed to finding a solution to the music licensing issue in Germany that will benefit artists, composers, authors, publishers and record labels, as well as the wider YouTube community,” they added.
Gema’s court case was based on 12 separate music clips posted to the website. The ruling concerns seven of the 12 clips.
If YouTube is forced to pay royalties for all the clips used on the site it will face a huge bill.
Gema represents about 60,000 German song writers and musicians.
If enforced, the ruling could also slow the rate at which video is posted to the site as any music clip would have to be cleared for copyright before being used.
Currently, it is estimated that about 60 hours of video is uploaded to YouTube worldwide every minute.
YouTube owner Google has yet to comment on the ruling.
The court case began in 2010 and came after talks between YouTube and Gema about royalties broke down. In 2009, the stalemate meant that videos from German recording firms were briefly blocked on the site.
Gema has rung up several victories against sites it has claimed are using music without paying royalties.
In 2009, file-sharing site Rapidshare was told to start filtering songs users were uploading following action by Gema. In March, 2012 a second judgement told Rapidshare to be more proactive when hunting down content pirated by users.
Music streaming site Grooveshark pulled out of Germany claiming licencing rates set by Gema made it impossible to run a profitable business in the country.