The European Commission started legal action against Britain on Tuesday for what it called a failure to keep people's online details confidential.
The move is part of a wider push by the EU's executive branch to ensure privacy is not abused by new technologies that electronically tag a consumer's every step.
EU Telecoms Commissioner Viviane Reding said the action related to how Internet service providers used Phorm technology to send subscribers bespoke advertisements based on websites they had visited.
Shares in Phorm closed down 2 percent at 500 pence in London after moving higher before the EU announcement.
Britain has two months to respond to the charges outlined in the letter of formal notice from the Commission.
A spokeswoman for Britain's Department for Business said: We take our data protection and e-privacy obligations very seriously. We will be considering the issues raised by the Commission and will respond within the required time frame.
BT admitted in April last year that it had tested Phorm in 2006 and 2007 without telling its customers, the Commission said.
The trials sparked snooping accusations from privacy groups and concern from the founder of the World Wide Web, Tim Berners-Lee.
British telecoms regulator Ofcom had no comment.
Phorm said its technology complied with EU laws.
We do not envisage the Commission's proceedings will have any impact on the company's plans going forward, Phorm said.
Phorm's technology did not store personal data or browsing histories, the company said.
Reding said Internet users in Britain had complained about the way the United Kingdom applied EU rules on privacy and electronic communications that are meant to prohibit interception and surveillance without the user's consent.
We have been following the Phorm case for some time and have concluded that there are problems in the way the UK has implemented parts of the EU rules on the confidentiality of communications, Reding said.
BT carried out new, invitation-based trials of Phorm in the final quarter of 2008, which resulted in a number of complaints.
BT was tight-lipped about the case, saying only, No comment on this, which is between the government and the EU. Our position re Phorm is unchanged. We are still evaluating the trial and have nothing further to add.
The Open Rights Group, which has been campaigning against Phorm in Britain, welcomed Reding's move.
BT should respect everyone's privacy and drop their plans to snoop on the Internet before they damage their own reputation further, the group's executive director, Jim Killock, said.
Phorm has said it is in talks with two other British Internet service providers, Virgin Media and Carphone Warehouse, and has launched a South Korean trial.
The Commission said the UK rule that interception was lawful when the service provider had reasonable grounds to believe consent had been given was too open and could be abused.
Reding was also concerned that Britain has no independent national supervisory authority dealing with interceptions. He called on Britain to change its national laws to ensure there were proper sanctions for breaches of EU rules.
Unless Britain complies, Reding has the power to issue a final warning before taking the country to the European Court of Justice, the 27-nation EU's top court.
If the court rules in favor of the European Commission, it can force Britain to change its laws.
Later this month, Reding will publish guidelines for EU states on the development and use of smart chips known as Radio Frequency Identification (RFID) technology, which have been dubbed spy chips by critics.
The Commission is also keeping a close eye on social networking sites.
(Additional reporting by Georgina Prodhan in London; editing by Andrew Macdonald and Karen Foster)