Guenter Verheugen, the European Union's industry commissioner, wrote to German states telling them they had a month to rework their draft legislation.
The warning comes after the EU had also criticised Denmark, Finland and Hungary for blocking foreign betting firms.
In many European nations, betting is still a state-controlled monopoly.
However, EU countries are not allowed to block firms of other member states from operating in their home markets if they allow domestic companies to operate gambling sites and lotteries, and run betting operations.
Ban 'disproportionate'
The Reuters news agency quoted an unidentified EU policymaker as saying that the German plans were inconsistent because they allowed horse racing but banned other forms of gaming.
The Commission said it had asked Germany to reconsider the total ban on lottery and sports betting on the internet.
"We think a proposed total ban is disproportionate and there are less restrictive measures, such as mandatory prior registration and strict guarantees on identification," the Commission said.
The UK and Austria challenged the ban, and among the companies that stand to benefit from a more open European gambling industry are British firms Ladbrokes, Stanley Leisure and Unibet, and Austrian operator Betandwin.com.
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