Plans to give the police and security services powers to monitor all emails and web visits must undergo a "fundamental rethink".
The Deputy Prime Minister said ministers needed to "go back to the drawing board" after a committee of MPs and peers found measures supposed to enable investigators to keep pace with technological developments went far further than necessary and amounted to overkill.
The committee, set up to examine the draft Communications Bill, accused the government of using "fanciful and misleading" figures to support its case for the legislation.
Clegg said ministers must take account of the committee's findings and that the Bill - dubbed a "snooper's charter" by critics - could not proceed in its current form.
"I believe the coalition government needs to have a fundamental rethink about this legislation. We cannot proceed with this Bill and we have to go back to the drawing board," he said.
"We need to reflect properly on the criticisms that the committee have made, while also consulting much more widely with business and other interested groups."
His comments will exacerbate tensions with Home Secretary Theresa May, who is responsible for driving the legislation through Parliament.
The committee said under the draft Bill, the Home Secretary would be given "sweeping powers to issue secret notices" ordering communications companies to disclose "potentially limitless categories of data".
Ministers argue that proposal, known as clause one, has been kept deliberately wide so it can be "future-proofed".
But the committee dismissed the argument and criticised the government for failing to properly take account of the right to privacy.
Committee chairman Lord Blencathra said: "There is a fine but crucial line between allowing our law enforcement and security agencies' access to the information they need to protect the country, and allowing our citizens to go about their daily business without a fear, however unjustified, that the state is monitoring their every move," he said.
"Whilst the joint committee realise that there are specific data types which are not currently available, and which would aid the work of law enforcement bodies and the security services, we are very concerned at how wide the scope of the Bill is in its current form."
Clegg acknowledged that new powers were needed by the law enforcement agencies to fight crime, but said they must take account of the committee's concerns.
"That must be done in a proportionate way that gets the balance between security and liberty right," he said.
"Any modernisation of the powers, including possible new legislation, must meet the concerns of the joint committee by having the best possible safeguards and keeping costs under control."
The committee found the government was using figures to attempt to show that under the reforms, spending £1.8 billion over 10 years would recoup three times that amount "when this is not the case".
It said the tally was based on police estimates of how many people would be saved in "threat to life" cases and the savings that would generate, including to the criminal justice system.
"The figure for estimated benefits is even less reliable than that for costs, and the estimated net benefit figure is fanciful and misleading," the report said.
"It ought not to be used to influence Parliament in deciding on the relative advantages and disadvantages of this legislation."
MPs and peers also criticised government claims that a quarter of the communications data required by investigators is unavailable, rising to 35 per cent within two years if action is not taken.
"We are of the strong view that the 25 per cent data gap is an unhelpful and potentially misleading figure," their report said.
The committee warned that plans to retain web logs carried a "possible risk" of being hacked or falling into the wrong hands, which would allow "potentially damaging inferences about people's interests or activities" to be drawn.
Lord Blencathra added: "The breadth of the draft Bill as it stands appears to be overkill and is much wider than the specific needs identified by the law enforcement agencies.
"We urge the government to reconsider its zeal to future-proof legislation and concentrate on getting the immediate necessities right."
It comes as a separate committee of MPs, which scrutinises security and intelligence agencies' administration and spending, warned more work must be done on the draft Bill if the government wants to win over parliament and the public.
The Intelligence and Security Committee, which has sent a classified report on its findings to Prime Minister David Cameron, also called for more detail to be included in the Bill.
It added: "We do not believe that there is any benefit in providing superficially precise estimates of the size of this 'capability gap': unless there is a demonstrable basis for such figures, they can be misleading.
"They can also detract from consideration of the problem itself, which is not necessarily linked to the size of the gap - even a small gap could have a disproportionately large impact."
Under the draft Bill, the records kept for a year will include details of emails, web phone calls and activity on social networking sites - but not their content.
Real-time monitoring will not be introduced.
Police, the security services, the new National Crime Agency and HM Revenue and Customs (HMRC) will be able to access the data, but the draft Bill also gives the Home Secretary the power to extend access to others, such as the UKBA.
Earlier this month May defended the plans, saying they would save lives.
"People who say they are against this Bill need to look victims of serious crime, terrorism and child sex offences in the eye and tell them why they're not prepared to give the police the powers they need to protect the public," she said.
A Home Office spokesperson said: "This legislation is vital to help catch paedophiles, terrorists and other serious criminals and we are pleased both scrutiny committees have recognised the need for new laws.
"We have now considered the committees' recommendations carefully and we will accept the substance of them all. But there can be no delay to this legislation. It is needed by law enforcement agencies now."
Lib Dem home affairs spokesman Julian Huppert dismissed May's support for the Bill and expressed concern about the breadth of the measures.
He told BBC Breakfast: "This is the sort of rhetoric that we were used to hearing from home secretaries from the last government arguing for 90-day detention without charge.
"And actually it is not just me and the Liberal Democrats who are concerned about this. Today there have been two reports published by cross-party, cross-House committees - I served on one of them - which unanimously express concerns about the Bill the Home Secretary proposed."
He added: "It is very, very dangerous once you start collecting huge amounts of data on literally everybody on the country... that is incredibly dangerous."
Huppert said many people would be "uncomfortable" that websites they visited, such as for abortion providers or marriage counsellors, were logged.
He also expressed concerns that the location a text was sent from could be stored.
Huppert said: "While we all want to see a proper fight against organised crime, this is not the way to do it.
"What we have said is this Bill as it is - which is incredibly broad - cannot happen. But there are specific powers and specific reforms which might well be possible."
Conservative Security Minister James Brokenshire said the government accepted the "substance" of the committee's report.
"We know that there is work that needs to be done and I absolutely accept that," he told the BBC Radio 4 Today programme.
"What we want to do is work through on these points, recognising that the Deputy Prime Minister has set out his concerns and making sure that the substance of the recommendations from the joint committee are addressed. We agree with that, that's what we will now be doing.
"There are always differences in coalition, that's what coalition is about, but we are intent on working this through because this matters, this is about saving lives and protecting the public and that is our absolute focus - on getting it right."
He added: "I think there is a legitimate debate to be had over the balance between security and individual liberty.
"In essence that's what's at the heart of the recommendations of the joint committee and the Home Secretary and I certainly acknowledge that and when you look at the steps the government has taken on a range of crime issues, on security issues, we have sought to rebalance that so it is properly meeting the needs of the collective versus the needs of the individual."
Writing in The Sun, May said: "Countries across the world are taking action now to help them track paedophiles and terrorists who abuse new technology to plot their horrific crimes.
"We must not get left behind. You and your loved ones have the right to expect the government to protect you from harm.
"Politicians from all parties have agreed that new laws are needed to help the police keep pace with changing technology. Parliament has made suggestions about how our plans could be improved and we will accept the substance of its recommendations.
"But Sun readers should know that I will not allow these vitally important laws to be delayed any longer in this Parliament.
"This law is needed and it is needed now. And I am determined to see it through."