The government's move to put its data-for-funding plan on the back-burner in favour of a new system an "embarrassing U-turn", says Labour.
The policy, which had been due to kick in from July, would have required community groups to hand over client data in order to be eligible for state funding.
Officials have now been sent back to the drawing board to come up with a better approach.
It comes after a series of setbacks including a data breach which saw an IT system scrapped and a top government official step down.
Privacy Commissioner John Edwards last month said the data-for-funding plan was "excessive" and the Social Development Ministry acted "prematurely" without considering privacy risks.
Mr Edwards said the policy could scare off the most vulnerable people from seeking help because of fear their details would not stay private.
Social Development Minister Anne Tolley said a working group would be set up to work with NGOs and statisticians to determine the best way to collect data.
"We've taken advantage of the hiatus that we created ourselves," she said.
"We need something that's co-designed with the sector itself in order to give them and us confidence."
That working group will be led by the Social Investment Agency and overseen by its minister Amy Adams.
Ms Adams said there had to be a "mutual respect" between the government and the social service providers.
"We think there's some real merit in working through ... what data use is appropriate, how we can best collect it, where the lines should be."
"It makes sense for the Social Investment Agency to lead this work as the data we need to collect and analyse will be used by the wider social sector," Mrs Tolley said.
The government hoped a new system would be in place by the beginning of next year.
Labour MP Carmel Sepuloni said the government had finally accepted defeat in "an embarrassing U-turn".
She said "the data grab" from vulnerable citizens had been "shambolic" and "draconian".
"After months of criticism and mismanagement, the government has finally cut its losses and backed down from its callous demands."
She said Amy Adams had clearly been pulled in to fix up the mess after Mrs Tolley's "abysmal handling".
But Prime Minister Bill English denied that.
"Anne has a good practical grip of what's required there ... It's really about getting the decisions made in a way that means they can apply across the government and across community groups. And you can't do that in one government department."