The Grade-II listed prison was shut in 2013 and Reading Borough Council hoped to take it over for redevelopment.
However, after a two-year wait for a Ministry of Justice decision, it has been told HMP Reading will be retained.
Reading Labour Party has now started an online petition calling on the government to reverse its decision.
Deputy council leader Tony Page described the news as a "bombshell" and a "major reversal" by the government.
The council's discussions on alternative uses for the site have involved English Heritage and the Ancient Monuments Commission.
One plan would see it becoming part of the regeneration of the town's Abbey Quarter, the 12th Century ruins where Henry I was buried.
Mr Page said: "A unique opportunity is in danger of being lost as a result of government dithering and procrastination.
"My appeal to Michael Gove and the government is to reconsider their decision and advance the disposal of the Reading Prison site as soon as possible so as to dovetail into the exciting regeneration of the adjoining Abbey Quarter."
The letter from Andrew Holdsworth, head of estates strategy at the MoJ on behalf of the Secretary of State for Justice, stated: "It is sensible that we have contingencies in place to deal with unexpected events such as a larger than projected increase in the prison population.
"This allows us to have reserve capacity without the cost of keeping them fully operational.
"The site at Reading is one of these contingency options, although I must emphasise that there are no current plans to reopen it.
"While we will not dispose of the site until further notice, we will continue to consider potential future uses."
A government decision to keep Reading jail ready for operation in case of contingencies has been described as "disastrous" by a council.