Trenton Mayor Douglas Palmer argued he had exempted Santiago from the residency requirement.
But Superior Court Judge Linda Feinberg says the waiver was not valid.
Santiago's lawyer says they will seek to put the ruling on hold and then appeal.
The City Council and some residents sued to get rid of Santiago.
Palmer appointed Santiago in 2003 after he served seven months as superintendent of the state police under former Gov. James McGreevey.
He was Newark's police director before then.
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