In another setback for the state health agency charged with rooting out Medicaid fraud, an appeals court Thursday said $1.26 million was improperly withheld from a dental practice even after state regulators acknowledged that no fraud had taken place.

The 3rd Court of Appeals ordered the money to be paid to the practice, ruling that the state Health and Human Services Commission was being unreasonable by continuing to withhold the payment.

The issue began in 2011 when the commission and its investigative arm, the Office of Inspector General, began withholding 100 percent of the Medicaid orthodontia payments to Harlingen Family Dentistry. The agency said it found a credible allegation that the dental practice was engaging in fraud by submitting bogus reimbursement requests.

After a trial, however, an administrative law judge determined in January that there was no fraud involved, merely billing mistakes that amounted to about 9 percent of the practice’s reimbursement claims. The judge ordered the commission to pay 91 percent of the money withheld, or $1.26 million.

The health commission formally adopted the judge’s findings but later declined to repay Harlingen Family Dentistry, arguing that the judge’s ruling applied to future payment holds, not money already withheld. The dental practice sued.

The appeals court rejected the state’s argument Thursday, saying the agency lost the ability to deny payment when it adopted the judge’s findings that fraud had not occurred.

“The state’s right to temporarily possess any of these funds was based solely on the existence of credible evidence of fraud,” the court said.

The ruling was another setback for the health commission’s Office of Inspector General, which this month was harshly criticized in a state audit for failing to distinguish between serious misconduct and minor transgressions and for misusing its authority to withhold payments from providers as unfair leverage to compel financial settlements.

The Sunset Advisory Commission determined that the behavior had caused “real harm” to medical providers and, ultimately, to taxpayers.