"The request has been rejected," said Federal Constitutional Court top judge Andreas Vosskuhle about the bid to ban the neo-Nazi party, which has around 6,000 members.
He added that "the NPD pursues anti-constitutional goals, but there is currently no concrete evidence... To suggest that it will succeed."
The case marks the second failed attempt to outlaw the National Democratic Party of Germany, with the latest launched by the Bundesrat upper house of parliament which represents Germany's 16 states.
The Bundesrat had launched the challenge in 2013, as the country was reeling in shock over the 2011 discovery of a murderous group calling itself the National Socialist Underground.
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Racist killings by the group had prompted Germany to crack down against right-wing extremism.
But since then, the NPD has lost its remaining seats in state parliaments, retaining just one representative, Udo Voigt, in the European Parliament.
It has also lost ground to the anti-euro fringe party AfD, which has morphed into an anti-immigration force railing against the mass arrivals of refugees in 2015.
But the International Auschwitz Committee's vice president Christoph Heubner voiced dismay at the ruling, warning that it could spur extremists across Europe to champion more hate.
"How can it be that those who cheerfully celebrate the Holocaust and provoke new episodes of hatred in many municipalities may remain in the democratic spectrum?" he asked.
"This reality-blind and untimely decision sends a disastrous signal to Europe, where far-right and right-wing populists have found new partnerships and are now trying to transform the fear and insecurity of the population into hatred and aggression," he warned in a statement.
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