WASHINGTON — A federal appeals court yesterday threw out a controversial rule that sought to tighten oversight of the $1.2 trillion hedge fund industry, casting grave doubt on the government's power to regulate the fast-growing investment pools.

The U.S. Court of Appeals for the D.C. Circuit cited what it called an "arbitrary" rationale that the Securities and Exchange Commission employed to adopt the rule over fierce opposition two years ago. The rule prompted nearly 1,300 advisers each with more than 14 clients and at least $25 million under management to open their books to SEC inspection.

The court ruling came on the same day as disclosures that federal securities regulators are investigating Pequot Capital Management Inc., a $7 billion hedge fund, for possible insider trading, according to the fund and sources familiar with the government's probe. Pequot denied any wrongdoing.

Once the exclusive province of the wealthy, hedge funds increasingly have attracted interest from average investors and public-pension holders for their outsized returns and eye-popping compensation practices. Investigations have uncovered evidence of trading violations and other wrongdoing at nearly 80 funds, according to SEC statistics.

While hedge funds represent a small fraction of the nation's total investment, they are responsible for heavy trading volumes. Risky bets by high-profile Long Term Capital Management forced regulators to step in with a $3.6 billion bailout in 1998.

"That the Commission wanted a hook on which to hang more comprehensive regulation of hedge funds may be understandable," U.S. Appeals Court Judge A. Raymond Randolph wrote yesterday's unanimous ruling. "But the Commission may not accomplish its objective by a manipulation of meaning."

The three-judge panel criticized securities regulators for too broadly interpreting legal definitions as a way to bring hedge funds under their scrutiny. The court said the SEC had improperly counted each fund investor as a client in an effort to make many more advisers subject to oversight. In doing so, the SEC was "painting with such a broad brush" that the agency misinterpreted the Investment Advisers Act of 1940, the panel said.