The standing committee of the National People's Congress (NPC), China's rubber-stamp parliament, decided that the city's next chief executive will be elected by popular vote in 2017, but candidates must each be backed by more than half the members of a "broadly representative nominating committee".
Democracy activists in the semi-autonomous Chinese city say this means Beijing will be able to ensure a sympathetic slate of candidates and exclude opponents.
The pro-democracy group Occupy Central said it would go ahead with its threat to take over the city's Central financial district in protest, at an unspecified date.
Public discontent in Hong Kong is at its highest for years over perceived interference by Beijing, with the election method for the chief executive a touchstone issue.
"The principle that the Chief Executive has to be a person who loves the country and loves Hong Kong must be upheld," said the text of the decision, released by the official news agency Xinhua.
A vote by universal suffrage must have "institutional safeguards" to take into account "the actual need to maintain long-term prosperity and stability of Hong Kong", it said.
The nominating committee will pick two to three candidates, it added. The decision was passed unanimously.
NPC official Li Fei dismissed the democracy activists' demands, adding that Hong Kong's leader must be loyal to China's ruling Communist Party.
"The Hong Kong leader must be a person who loves the country and the Party. He should support the central government, its sovereignty and the benefits of development."
Leung Chun-ying, the city's current chief executive who was picked by a pro-Beijing committee, hailed the NPC's decision as a "major step forward in the development of Hong Kong's society".
"If we are willing, the majority of Hong Kong people, and that is some 5 million people eligible to vote, will no longer be bystanders in the next election," he told reporters.
- 'Darkest day' -
But Beijing's plan to vet candidates caused dismay among democracy advocates who said the proposal could not be considered genuine universal suffrage.
"There is no genuine choice. They (Beijing) will just give us one or two or three people they have chosen," Democratic Party chairwoman Emily Lau told AFP.
"This is one person, one vote, but there is no choice. They have that in North Korea but you can't call it democracy."
In an emailed statement, Occupy Central said: "All chances of dialogue have been exhausted and the occupation of Central will definitely happen".
A pro-democracy Hong Kong lawmaker broke down on live television after the NPC announcement, saying there was "no way out for Hong Kong".
"This is the darkest and most painful day for Hong Kong's democracy movement," said Ronny Tong of the Civic Party, sobbing on local broadcaster Cable TV.
His colleague Claudia Mo told AFP: "They're turning Hong Kong into a bunker and they can do whatever they want, basically.
Student leader Alex Chow said the NPC decision was "totally unacceptable".
"This is not universal suffrage, this is not democracy, it is about dictatorship, it's about controlling," he said. "We have no choice, we have to struggle and we have to fight back."
- Rival protests -
Britain handed Hong Kong back to China on July 1, 1997 under a "one country, two systems" agreement, which allows residents civil liberties not seen on the mainland, including free speech and the right to protest.
Since then the city's leader has been chosen by a 1,200 pro-Beijing committee. China promised a popular vote in 2017 but with strict curbs on candidates.
Pro-democracy protesters staged a mass march in July demanding a greater say over the choice of leader. The next month tens of thousands of people rallied against the Occupy Central campaign, in an event organised by the pro-government Alliance for Peace and Democracy (APD).
An unofficial referendum organised by Occupy activists saw the majority of 800,000 people who voted supporting public nominations for chief executive.
In a counter-move, the APD mounted its own petition, backed by pro-Beijing groups and officials, and said it collected some 1.4 million signatures.
The pro-democracy movement has been strongly criticised by Beijing and city officials as illegal, radical and potentially violent.
State-run media on the Chinese mainland stepped up a campaign against the "extreme pan-democrats" in the run-up to Sunday's announcement, alleging interference by foreign countries.
Xinhua warned early Friday in a strongly worded article that the central government has "comprehensive jurisdiction" over Hong Kong and "will always be involved" in its affairs.