The case has focused uncomfortable scrutiny on Walker, a prospective 2016 Republican presidential candidate who is up for reelection this year, and spotlighted how huge sums flow through politically active groups, unseen by the public.
Wednesday's ruling was boost to prosecutors, who in August 2012 began probing the relationship between top Walker strategists and a network of conservative groups such as the Wisconsin Club for Growth, which spent millions to help him and other Republicans fend off recall efforts.
In May, U.S. District Court Judge Rudolph Randa halted the investigation, saying any coordination did not violate election laws because the outside groups were engaged in issue advocacy, not explicit political activity.
The governor was not a target of the investigation at the time it was stayed, according to Joseph M. Russell, an attorney for Francis Schmitz, the special prosecutor leading the case.
Russell said in a statement Wednesday that the Seventh Circuit decision reversing Randa reinforced "that the government is entitled to regulate expenditures that are coordinated between candidates’ campaigns and purportedly independent advocacy groups."
David B. Rivkin, Jr., attorney for the Wisconsin Club for Growth, said the group plans to appeal the panel's decision to the full Seventh Circuit, adding that it has endured a "years’ long campaign of harassment and intimidation."
"We will ask the Seventh Circuit to correct today’s mistaken decision, and we will continue to fight this abuse of government power," he said in a statement.
In a unanimous decision written by Circuit Judge Frank H. Easterbrook, the Seventh Circuit panel said the case was not a matter for the federal courts, noting that the investigation was already pending in Wisconsin state courts. In January, a former state appeals court judge overseeing the probe, Gregory A. Peterson, had quashed subpoenas sought by prosecutors.
“The state case might be over today had the district judge allowed it to take its course," the panel wrote.
Walker's reelection campaign released a statement saying that the ruling "has no impact on the fact that Judge Peterson shut down this investigation in January."
In fact, Peterson stayed his own order requiring prosecutors to return material they had seized as part of the case. He said the case should be reviewed by the state appellate court, saying that the prosecutors' theory "is not frivolous" and raised "significant constitutional arguments."
The investigation, which is being challenged on several fronts in state courts, is expected to ultimately end up before the Wisconsin Supreme Court.
Robert Barnes contributed to this report.