The Second Circuit Court of Appeals intervened in the ongoing fight between the Securities and Exchange Commission and a federal judge yesterday, when they granted a stay in a ruling in a mortgage backed securities case against Citigroup.

The SEC confirmed Wednesday morning that the Second Circuit Court of Appeals granted a stay to the underlying litigation stemming from the SEC’s investigation of collateralized debt obligations linked to Citi. The stay stops the underlying litigation between the parties temporarily while the attorneys work through another appeal.

The decision reverses an opinion released by a U.S. District judge who denied the stay earlier in the day.

Judge Jed Rakoff with the U.S. District Court for the Southern District of New York held that “because interlocutory appeals derail the orderly conduct of lawsuits and result in piecemeal and duplicative litigation, such interim appeals are strongly disfavored in the federal system.”

The parties asked for the stay of litigation while they wait for a decision on their appeal of Judge Rakoff’s decision not to accept a $285 million settlement between the two financial firms to compensate investors who lost money on a $1 billion Citi CDO tied to risky mortgages.

Basically, you have Citigroup and the SEC working in tandem against Judge Rakoff. Citigroup supported the stay on the litigation, for obvious reasons. The SEC also wants to avoid litigation. But the judge denied the settlement as insufficient to the crime committed, particularly because it followed the accepted practice of allowing Citigroup to pay their way out of the problem without admitting any wrongdoing.

The other part of this is that there’s a secondary lawsuit against specific individuals at Citigroup, which Rakoff sought to fold into this case. But all of that is on hold now. The 2nd Circuit will decide quickly whether they will hear the appeal of Rakoff’s ruling on the settlement, before January 17. Business Week has more on that.

Rakoff has been one of the few judges in the federal system willing to blow the whistle on the unseemly practice of slaps on the wrist and settlements without admission of wrongdoing that has characterized the federal regulatory approach to the financial system since the crisis began. Now the regulators are appealing to a higher court, to get out from under Rakoff’s boot.