Moira Deeming lost a preselection contest for top spot on the Liberals' Western Metropolitan ticket at the party's Melbourne headquarters on Sunday.
She and fellow upper house MP Trung Luu were defeated by businessman and Indian community leader Dinesh Gourisetty, who garnered support from the party's moderate wing.
The party's state executive will need to endorse the vote.
Dressed in a Liberal blue jacket, Mrs Deeming left the meeting without answering reporters' questions.
She did not put her hand up for second position on the ticket.
Mrs Deeming secured preselection endorsements from former prime minister Tony Abbott, Sky News commentator Peta Credlin and Opposition Leader Jess Wilson.
Ms Wilson made no apology for supporting her preselection and that of other sitting incumbents over challengers.
"I back my team," she told reporters before the meeting.
Two Liberals were elected in the upper house region in 2022.
Support for One Nation has surged nationwide, with the right-wing party receiving almost 23 per cent of first preference votes in the South Australian state election.
Ms Wilson would not be drawn on whether the result could prompt Mrs Deeming to defect to One Nation.
Mrs Deeming has made headlines since she was preselected by the party in 2022.
The former high-school teacher was suspended after she attended a 2023 Let Women Speak rally gatecrashed by neo-Nazis.
She was later expelled from the Liberal party room after she threatened legal action against then leader John Pesutto, who was ultimately found to have defamed her by implying she was associated with neo-Nazis and ordered to pay $2.3 million in legal costs.
Mrs Deeming was welcomed back into the parliamentary party in December 2024 and named former leader Brad Battin's representative for the western suburbs.
Mrs Deeming offered to defer some of Mr Pesutto's legal bill in exchange for conditions including her preselection but the proposition was rebuffed.
The state Liberals' administrative committee agreed to lend Mr Pesutto $1.55 million to settle his debt to Mrs Deeming and avoid bankruptcy.
The loan prompted an ongoing legal challenge from a group of breakaway Liberals.
In another preselection battle, Liberal upper house leader Bev McArthur survived a challenge on Saturday from former Geelong mayor Trent Sullivan for her top spot on the Liberals' Western Victoria ticket.
Former Burwood MP Graham Watt won second spot.
It comes after shadow cabinet member Renee Heath retained top spot in Eastern Victoria and Ann-Marie Hermans dropped to second in South-Eastern Metro behind former electorate officer Phillip Pease.
Victorians head to the polls in November, with the coalition vying to end 12 years of Labor rule.
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