The BBC's controversial proposals to launch a £68m network of local news websites with video content have been rejected by the BBC Trust.

Sir Michael Lyons, the BBC Trust chairman, today told the corporation's management, led by the director general, Mark Thompson, to instead concentrate on "improving the quality of existing services".

In its provisional conclusions on the public value test (PVT) on the local online video plans published today, the trust said the proposed network of more than 60 websites "would not improve services for the public enough to justify either the investment of licence fee funds or the negative impact on commercial media".

The trustees made their PVT decision based on evidence provided by trust officials in a public value assessment and Ofcom's market impact assessment (MIA) – both of which delivered a negative verdict on the local online video proposals.

The PVA concluded that a broadband-only local video proposal would not extend the BBC's reach to those audiences that are not receiving a good service at present.

Ofcom's MIA concluded that a BBC local video network, which has faced vociferous opposition from newspaper publishers, would have a "significant negative impact on commercial providers".

The MIA found that if the BBC local video services were launched, annual revenues from existing commercial providers would fall by up to 4%.

"It is clear from the evidence that, although licence-fee payers want better regional and local services from the BBC, this proposal is unlikely to achieve what they want," Lyons said.

"We also recognise the negative impact that the local video proposition could have on commercial media services which are valued by the public and are already under pressure," he added.

Lyons said that the BBC's priority should be improving the quality of existing services.

"The public wants better quality regional television news programmes and more programmes of all kinds produced in and reflecting their areas. We would expect BBC management to consider carefully the conclusions of this public value test before returning to us with new proposals," he added.

Lyons said the decision to refuse permission for the video network would mean that "local newspapers and other commercial media can invest in their online services in the knowledge that the BBC does not intend to make this new intervention in the market".

The trust has instructed that the £68m in funding earmarked for the proposed service is removed from the BBC's Nations and Regions budget and returned to central funds.

BBC management will also have to get trust approval for their alternative investment plans for the money allocated to the local online video project.

"The trust has asked the [BBC] executive to consider their own response carefully and in particular whether existing regional and local television and radio services can better address the performance gap originally identified by the trust," the corporation's regulatory and governance body added.

BBC management said it accepted the trust's findings that the local online video plan "would not be appropriate in the foreseeable future".

"Management believed that the local video proposal would strengthen the BBC's news coverage for local communities and deliver real value for licence-fee payers," it added.

BBC management said that it would "pursue with vigour" the trust's challenge for it to improve existing local and regional TV, radio and online services to "ensure audiences across the UK see a better reflection of their local communities".

"We will consider a range of options for how we can best achieve this and will return to the [BBC] Trust in due course," management added.

Thompson said today's decision showed that the BBC Trust's PVT was not a foregone conclusion, as some critics had claimed.

"Today's announcement is part of the system working rather than not working. The right thing to do is to recognise today's decision and not come back to it for a good long while," added the BBC director general, speaking at an Ofcom conference on the future of the internet in London.

Thompson said the BBC should not be free to act on any "brilliant idea" without reference to the market impact but nor should the BBC or any other public broadcaster be trapped at a particular moment in time, since the audience's needs are constantly changing.

He added that there had been three or four public value tests so far, with the trust's previous decisions requiring various degrees of amendments to BBC management's original plans – but this was the first outright rejection.

The trust's decision not to approve the local online video plan is now open to public consultation until January 5 next year, with a final decision due by February 25.

The BBC's plan would have seen the launch of 65 local video services – across 60 areas of the UK with five Welsh-language services – covering news, sport and weather with 400 staff and a total budget of £68m up to 2013.

Each of the local websites would have had the equivalent of around £350,000 a year in funding.

However, the PVA pointed to groups including those on low incomes or living in remote areas who may not have access to broadband and therefore would see no benefit from the BBC local video plan.

In addition, younger audiences would prefer a local video service with a wide range of commercial content, such as cinema listings, which the BBC does not provide, the PVA said.

The PVA added that older people would prefer an improvement in the quality of existing BBC regional TV and radio news programmes.

And the 35- to 45-year-old demographic, a target audience for local video, are more likely to be interested in news about local schools and hospitals, according to the PVA.

However, the PVA said that this demographic "typically have less time to search for content on the web" and with their children often online "they turn to TV, radio and newspapers instead".

"Against the background of increased financial pressures on the BBC, the public value assessment concluded that the service would not create significant new reach or impact in return for the investment of licence fee funds," the trust said.

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