Council has rejected a bid by Katoomba Theatre Company to apply for government grants to refit the old Katoomba Library as a theatre space.
KTC's artistic director, Larry Buttrose, said the group of volunteers was "pretty shocked" at the news that council had voted 5-4 against a motion to give "owners consent" to allow grant applications to be made.
"It's extremely frustrating that we have not managed to get consent from council to raise federal and state government funds," he said.
But the four Labor councillors and independent Brendan Luchetti (Clr Romola Hollywood was absent) said council had yet to make a final determination about what the space would be used for and who would manage it.
Mr Buttrose said he had hoped to apply to a new federal government fund called the National Stronger Regions Fund, designed to help boost regional employment and economic activity.
"This is a shovel-ready project. It could be achieved in a few months if anyone ever gave us the permission to raise the money," he said.
"We do regard this as a serious punch in the guts for the campaign for a theatre but we hope to be able to work with council towards this goal for the community's good."
Clr Daniel Myles had introduced the motion, pointing out that council did not have the funds to convert the old library into a theatre space. "It would be up to other people to convert it," he said. "If people wish to secure government funding let them do it - it ought to be supported."
His fellow Liberals, Michael Begg, Chris Van der Kley and Brendan Christie, voted in favour.
The mayor, Mark Greenhill, who opposed the motion, said council had previously voted to give the community an opportunity to use the space before making a final determination about its future.
"We are midway through a process that will involve the presentation of proposals that are to be at zero cost to ratepayers. This process was unanimously supported by the whole council just a few months ago. It seems strange to me that there was an attempt to bypass this.
"My concern is we would effectively be giving one organisation a sense of momentum that others wouldn't have."
Clr Don McGregor said later that the premises review panel was still considering the end use of the hall and two expressions of interest.
"If agreed to, this motion would have predetermined the ultimate use of the hall and pre-empted the findings of the panel," he said.
As well as KTC, council had received a second expression of interest from an alliance of arts professionals, community groups, an environmental research group and some indigenous organisations.
"They sought to advise and promote a multi-purpose facility under council management with guaranteed equity of access. They suggested a modest fit-out as funds became available so that it was capable of accommodating a range of performing arts and community events."