The judgement is being seen as a significant blow to the state government.
The government regards the armed groups as an important part of its battle against Maoist insurgents.
Chhattisgarh is one of the states at the heart of the Maoist rebel insurgency.
The Supreme Court ruling covers two types of armed group.
Special Police Officers (SPOs) have a semi-official status. They receive small salaries from the government, are armed by the authorities and have basic training.
The Salwa Judum movement is less formalised. The government has sometimes described it as a spontaneous response to the Maoist insurgents.
But the authorities have certainly supported them, encouraging villagers to organise themselves into anti-Maoist forces, says the BBC's Jill McGivering, who has visited the area.
Some of these villagers also received training and guns.
Human rights concerns
Our correspondent says these local groups do have clear advantages over India's paramilitary forces.
They have a specialist knowledge of the jungle terrain and nearby communities and can understand local dialects. They can also provide valuable intelligence to the security forces.
But there have been human rights concerns about their role as armed law enforcers, partly because of the lack of clarity about their powers and accountability.
Some of them have been accused in the past of attacks on other villages, of destroying houses and killing people who were allegedly pro-Maoist.
Critics say that the fact they have government support and can act with impunity has also undermined the rule of law and blurred the lines between fighters and civilians.
A key question is how effectively the Supreme Court ruling will be implemented. Monitoring the process will not be easy in the state's remote forests.
The ruling could have implications, too, for other Indian states with similar state-supported militias.
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