Prime Minister Narendra Modi's decision, in line with his Make-in-India policy to encourage domestic industry, is a blow for not only the French manufacturer but also others circling over the Indian military aviation market worth billions of dollars.
Since it took over last year, the Modi administration has repeatedly said its overriding goal is to cut off the military's addiction to foreign arms which has made it the world's top importer.
The air force wanted the government to clear an additional 44 Rafale medium multirole aircraft on top of the 36 that Modi announced during a visit to Paris this year that are to be bought off-the-shelf to meet its urgent requirements.
But a defense ministry official said that Defense Minister Manohar Parrikar had told the air force that there weren't enough funds to expand the Rafale acquisition and that it must induct an improved version of the indigenous Tejas-Mark 1A.
"The IAF (air force) needs to have a minimum number of aircraft at all times. The LCA is our best option at this stage, given our resource constraints," the defense official said.
"The Rafale is our most expensive acquisition. The LCA is our cheapest in the combat category."
India's air force says its requires 45 fighter squadrons to counter a "two-front collusive threat" from Pakistan and China. But it only has 35 active fighter squadrons, parliament's defense committee said in a report in April citing a presentation by a top air force officer.With the drawdown of Soviet-era MiG 21 planes under way, the air force would be down to 25 squadrons by 2022 at the current pace of acquisitions, it told the committee.
Cleared by the government in 1983, the LCA designed by the government's Defense Research and Development Organisation (DRDO) was meant to be the backbone of the air force due for induction in 1994.
Instead, it suffered years of delay and chaos with scientists trying to build the world's most modern light combat aircraft from scratch, including the engine.
Eventually they scrapped the engine, turning to GE Aviation and lowering their ambitions for a state-of-the-art fighter. So far, only one aircraft has been produced and even that is awaiting final operational clearance, now delayed to early 2016.
"In January this year, they had given one LCA ... which had not completed its flight testing. They handed over the papers to us. We do not make a squadron with one aeroplane. That is where we are," said an air force officer speaking on condition of anonymity.
An independent investigation by the Comptroller and Auditor General of India into the LCA program identified 53 "shortfalls" in the plane. In a report in May, the auditor said that the plane wasn't as light as promised, the fuel capacity and speed were lower than required and there were concerns about safety.
Retired Air Marshal M. Matheswaran, a former deputy chief of the Integrated Defense Staff, said the LCA was obsolete.
"It is a very short-range aircraft which has no relevance in today's war fighting scenarios. If you are trying to justify this as a replacement for follow-on Rafales, you are comparing apples with oranges."
He said the plane was at best a technology demonstrator on which Indian engineers could build the next series of aircraft, not something the air force could win a war with.
"We would like to have the MMRCA (Medium Multi-Role Combat Aircraft) variety of aircraft. At least about six squadrons, to my mind," the head of the air force, Arup Raha, said at the weekend, referring to the Rafale class of fighters.
But K. Tamilmani, the DRDO's aerospace chief, said the modified version of the Tejas addressed most of the air force concerns. These included electronic warfare system, flight computer, radar and maintenance problems.
"Almost all the problems get solved with the 1A. There will always be scope for improvement, but there are no flight safety issues," he said.
State-run Hindustan Aeronautics Limited would be able to ramp production to 16 a year by 2017 to meet the air force's demands, he said.
"We Indians are extremely good at blaming each other - at blaming it all on Indian production."
Dassault declined any comment on the government's decision to cap the Rafale fleet.
A source close to Sweden's Saab, which has been pushing its Gripen light fighter, said that it was respectful of India's decision to try to develop its domestic military base.
"There's still a huge gap that needs to be filled. We are marketing it (the Gripen) under the Make-in-India umbrella," he said. "Even if you add the seven squadrons of the Tejas, there is still a requirement (with MiGs retiring etc). It’s a question of timing. Can they build these for when they need them?"