Known as Project Castor, the scheme aimed to store gas in a depleted oil reservoir 1.7 kilometres (1.05 miles) under the Mediterranean Sea in the Gulf of Valencia and send it via a pipeline to Spain's national grid.
The government halted operations at the facility in September 2013 after more than 200 minor earthquakes were detected in the area which geologists and environmentalists blamed on gas injections.
The company which owns and operated the facility, Escal UGS, in June 2014 said it was giving up its concession for the gas storage project, which was financed by the European Investment Bank.
Deputy Prime Minister Soraya Saenz de Santamaria said Friday that the government had decided to "freeze the installations and ban the injection or storage of gas" at the facility.
It would also award Escal UGS €1.35 billion in compensation, she told a news conference.
Escal UGS is majority-owned by Spanish builder ACS, with nearly 67 percent, while CLP, a group controlled by Canada's Dundee Energy, has a 33-percent stake in the firm.