The legal action follows numerous complaints to the EC about BT, which tested Phorm in 2006 and 2007 without informing customers involved in the trial.
Last year Britain said it was happy that the online advertising technology conformed to European data laws but the Commission has said Phorm "intercepted" user data without consent and failed to keep people's online details confidential.
The EC said that Britain should ban internet traffic interception and monitoring unless users give explicit consent that their behaviour can be tracked and analysed.
Viviane Reding, the EU's telecoms commissioner, said in a statement: "Technologies like internet behavioural advertising can be useful for businesses and consumers but they must be used in a way that complies with EU rules.
"We have been following the Phorm case for some time and have concluded that there are problems in the way the UK has implemented parts of the EU rules on the confidentiality of communications."
Regulators sent a first legal warning to Britain on Tuesday asking it to change or explain the way it interprets EU rules because it currently allows interception when it is unintentional or when the tracker has "reasonable grounds" to believe that consent was given.
If Britain fails to change its national laws to enforce EU confidentiality rules the Commission has the power to issue a final warning before taking Britain to the European Court of Justice, which could force Britain to change its laws.
Phorm issued a statement in response to the news saying: "Phorm's technology is fully compliant with UK legislation and relevant EU directives. This has been confirmed by BERR and by the UK regulatory authorities and we note that there is no suggestion to the contrary in the Commission's statement today. We do not envisage the Commission's proceedings will have any impact on the company's plans going forwards.
"Furthermore, Phorm's system stands out from other online advertising systems in that it does not store personal data, or browsing histories. Finally, consistent with UK and EU legislation, and in anticipation of any changes that may be made to the law in the future, our system offers un-missable notice and clear and persistent choice to consumers."
Phorm has proved controversial with some campaigners claiming it breaks UK data interception laws.
BT asked for users' consent when it trialled the technology again from October to December 2008.
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