It describes Eileen McElligott - who is up against Pakistan-born Tory Azam Janjua - as "born and bred in Reading" and declares: "She will fight for us here in Church ward because she is one of us."
But that has angered figures across the political spectrum, including Lib Dems, Labour veterans and the Tories, who say it shows prejudice towards Cllr Janjua.
Tory deputy leader Cllr Jeanette Skeats said: "I am shocked that they should try to use racist dog whistle messages against a hard-working Conservative councillor who has lived in this country for almost 50 years."
Reading East MP Rob Wilson described it as "vile" and "beyond the acceptable knockabout of party politics" and said he takes "great exception" to attempts to brand his constituents as "racist". He added: "Residents in Church ward will comprehensively reject this title being hung around their neck by the local Labour Party."
The Flashing Blade internet blog - understood to be Andrew Tattersall, a former Labour councillor and husband of the party's ex-Reading East MP Jane Griffiths - said he is ashamed of his past connectionsd with the local party.
He added: "To have sunk so low as running a racist election campaign is the despicable act of some desperate men."
Conservative election agent Alison Swaddle has written to her Labour counterpart David Absolom demanding an apology and the leaflet's withdrawal.
But Mr Absolom countered by accusing the Tories of "smear tactics", threatened legal action should they repeat their comments publicly and told The Chronicle yesterday (Wednesday) they are seeking legal advice.
He said the Tories are trying to distract attention from their own problems, following the resignations of councillors Jamie Chowdhary and Mark Ralph amid reports of infighting,
He described Cllr Janjua, who resigned as a Labour councillor in 2007 following allegations of misconduct, as a political turncoat. He said the "one of us" reference to Ms McElligott was because she grew up on the Dee Road estate.
Mr Absolom added: "Labour voters in Church ward are entitled to know that their candidate is not likely to abandon her party and that she understands the issues that matter to them.
"In other words, she is one of us who understands just what damage the Conservative-led Government is doing to hard working families."