Cotswold Canals Trust missed out on the funding from the Heritage Lottery Fund for its ambitious project.
The scheme would have connected the sections of the Stroudwater Navigation and Thames & Severn canals under restoration with the Gloucester and Sharpness Canal.
Stroud Mayor Kevin Cranston said missing out on the lottery funding was a great disappointment.
“However, I know that the volunteers and enthusiasts involved in the restoration work will not be down hearted for long,” he said.
“They will overcome this latest setback, as they always do, and will continue to beaver away at finding funds and doing all the practical work that they can.
“Stroud Town Council remains fully committed to seeing the town reconnected to the rest of the national canal network.
“I remain optimistic that within a few years I will be able to board a canal boat in Stroud and sail off to visit relatives in Lancashire.”
The trust said it is determined to continue with parts of its planned restoration of the Stroudwater Navigation from Stonehouse and Saul.
It is discussing the possibility of making another bid for lottery funding after it received encouragement by the Heritage Lottery Fund on ways to increase its chance of success the next time.