Stranded air passengers would not be able to claim for more than three nights of accommodation under proposals from the European Commission.
Both consumer groups and airlines criticised the proposals, drawn up to take account of exceptional situations such as the eruption of Icelandic volcano Eyjafjallajokull, which stranded millions of people and cost airlines USD$1.7 billion.
The ash cloud released by the volcano closed European air space for six days in April 2010, and airlines paid one and a half times their normal annual compensation in just a week.
"Under current rules, air carriers must provide refreshments, meals and accommodation for an indefinite period of time, potentially threatening their financial survival," the Commission said in a paper outlining the proposal.
"We know that the real priority for stranded passengers is just to get home," Siim Kallas, the EU commissioner for transport, said in a statement.
The Commission also proposed that passengers be allowed to claim compensation only once flights are delayed by five hours for all intra-EU flights and short international flights of less than 3,500 km.
The European Court of Justice (ECJ), the highest in the European Union, ruled last year that passengers should be able to claim compensation for three-hour delays, unless they were caused by circumstances beyond the airline's control.
The Commission also said transport strikes should count as extraordinary circumstances, in which airlines would be liable for providing compensation.
Umbrella EU consumer lobby BEUC said it was disappointed that accommodation was capped at three nights and that compensation would only be available after five hours.
"Passengers are often left in limbo and without the support they should be entitled to," said Monique Goyens from BEUC.
Airlines had feared that a landmark ECJ ruling in another compensation claim, against Ryanair in January, would pave the way for larger payouts to customers and raise fares.
The court ruled that airlines were obliged to provide care, even in "extraordinary circumstances" such as the ash cloud.
Ryanair, Europe's leading no-frills airline, was taken to court after refusing to compensate Denise McDonagh for EUR€1,129 (USD$1,500) she spent on meals, accommodation and transport when her flight was cancelled because of the volcanic ash.
The Commission's new proposal also establishes that a passenger may not be denied boarding on the return leg of a ticket because they did not take the outbound flight.
The International Air Transport Association (IATA) said it was disappointed with the Commission's proposals because they would add new costs for air carriers.
In particular, IATA criticised a provision whereby an airline would have to reroute passengers with a competitor if a flight was cancelled and there were no seats available on its own services within 12 hours.
"If your Bic pen doesn't work, you don't expect to get a Mont Blanc as compensation," said Tony Tyler, director general of IATA.
The Commission's proposals will now pass to the more than 700-seat European Parliament and the EU's 27 countries, which can strengthen or weaken the rules before they become law.