The U.S. Supreme Court ruled that dozens of states can continue to offer special tax breaks on municipal bonds issued within their borders, preventing disruptions in a $2.6 trillion market.

The high court, voting 7-2 in a Kentucky case, said the Constitution lets states exempt interest earned on in-state bonds while taxing the income from bonds issued elsewhere. The decision preserves tax rules in 42 states, including New York and California.

A ruling against Kentucky might have transformed the industry. States would have faced billions of dollars in refund claims and been forced to either eliminate the tax breaks or extend them to out-of-state bonds. Such a ruling also would have undermined the appeal of the hundreds of single-state bond funds, which held $155 billion as of 2006.

Barring in-state tax exemptions would “radically” change the way municipal projects are financed and “upset the market in bonds and the settled expectations of their issuers,” Justice David Souter wrote for the court.

The ruling injects some stability into what has been a turbulent year for the municipal bond market. Bonds lost 0.82% in total return on average in the first quarter, the worst start since 1996, amid the collapse of the auction-rate market and selling by hedge funds, according to Merrill Lynch & Co.’s Municipal Master Index. Municipal bonds have since rebounded.

“This is one of the few things in the municipal bond that has gone as expected this year,” a managing director at Concord, Mass.-based Municipal Market Advisors, a research firm, Matt Fabian, said. “Now we can all go back to normal.”

A New York state general obligation bond maturing in 2020 traded yesterday at 100.911 cents on the dollar to yield 3.8%, up from $100.009 cents on the dollar to yield 3.998% on May 16.