The company applied to the Food Processing, Marketing and Co-operation scheme for funding to help it meet growing demand for its beers at home and abroad, and to maximise its tax efficiency.
Arran Brewery managing director Gerald Michaluk said ministers refused the grant on grounds the application for the proposed merger with the Isle of Skye brewery, announced last year, had "materially changed".
He said: "Without Government assistance, you would never put a brewery that size on an island, so we needed £1m from them.
"We would match it with a £1m from investors' money, and that makes it more palatable, but of course if there is no Government money, there is no investors' money. It is a major set-back for us."
The decision comes in spite of international companies, including HSBC, qualifying for tax-payer funded grant assistance in Scotland for creating jobs.
Mr Michaluk said the Arran Brewery had to expand on a major scale to ensure it did not become uneconomical.
Under the Small Breweries Relief scheme, brewers that produce 5000 hectolitres a year or less are eligible for 50% duty relief, with the tax benefit reducing on a sliding scale after volumes exceed that threshold.
Production at Arran is close to the 5000-hectolitre mark and if the merger with Isle of Skye Brewery goes through a further 2500 hectolitres of annual production will be added, raising duty costs by 9p per bottle.
The firm said its plans would have brought 10 more jobs to Arran, where it employs 20 staff, and 67 at a new bottling hall on the site of the former Rosebank Distillery in Falkirk, which it acquired last year.
Those plans have now been put on hold, with the business being forced to scale down the ambition of a share flotation it hoped would raise enough funds to match the Government grant.
Talks are also planned with staff on Monday to discuss the potential impact.
Mr Michaluk described the decision as a "major blow", and stated that expanding the brewery was not viable without government support because of its island location.
He said: "We make about 6p a bottle at the moment and if we go above the duty band we will land up not making any money. We will end up working harder and then losing money, so we needed a new brew house.
"Being on Arran, because there is no equivalent road tariff or anything, we end up paying a fortune on ferries."
Mr Michaluk criticised what he sees as the Government's inconsistent approach to supporting domestic food and drink suppliers.
He said: "When somebody actually makes the stuff where he says he makes it, [and] labels it correctly, it's a kick in the teeth."
A spokesman for the Scottish Government commented that the application "did not sufficiently meet the FPMC scheme criteria" however he added that Government ministers have "asked officials to continue to work with Arran Brewery to support them with their development plans".