Simran Kaur Cheema was selected to represent the party in Walsall Council's Pleck by-election, which is due to take place on December 16.
But it has now emerged she will be unable to sit as a councillor even if elected, as she was employed by the authority at the time her candidacy papers were signed off.
Conservatives have hit out at the blunder and called for the Labour Party to refund the estimated £20,000 cost of the by-election.
It marks the latest disaster for the borough's Labour group, which is already reeling after Willenhall South councillor and former leader Sean Coughlan was charged with child sex offences.
Under local government legislation, council employees are required to resign from their position ahead of being formally accepted as candidates for election.
It is understood that Ms Cheema resigned from her role with the borough's library service 24 hours after nominations for the by-election closed.
In a statement she said: "I put myself forward to stand for election to Walsall Council because I wanted to represent my local community.
"However, regretfully it has now been brought to my attention that due to the nature of my employment at the time of my nomination as a candidate, the requirements of electoral law mean I will not be in a position to take up the position on the council if I am elected in the upcoming by-election.
"I apologise to the voters and community of Pleck for not becoming aware of the issue sooner."
Under electoral law, the by-election must be held and Labour is unable to select another candidate as the nomination deadline has passed. Labour has dominated the ward for the past decade.
Councillor Adrian Andrew, Walsall Council's deputy leader, said: "This fiasco shows the complete incompetence from the Labour Party. They called this by-election when the seat was up for election in May anyway.
"It has cost around £20,000. It is a waste of taxpayers' money and we are calling on the Labour Party to refund the cost of the by-election to the good people of Walsall."
It is understood that neither Labour group leader Aftab Nawaz or Tory leader Mike Bird wanted the by-election in Pleck, where a seat is vacant following the death of Labour councillor Harbans Singh Sarohi in July.
The Labour Party has been contacted for a comment.