The suspect, aged in his fifties, was arrested in November 2015 as part of the long-running investigation into the murder of Yvonne Fletcher.
The 25-year-old female officer was killed while policing what had been a small and peaceful demonstration outside the Libyan embassy in London.
Her family said they were "deeply disappointed and frustrated" at today's news.
Supporters of Kadhafi -- the longtime Libyan dictator who would be killed in 2011 -- were holding a rival rally on the same day and "a number of shots were fired" from within the embassy, police said. Fletcher was fatally hit in the back.
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"The key material has not been made available for use in court in evidential form for reasons of national security". After a review prosecutors decided there was "insufficient admissible evidence to charge the man".
In a statement released by police, Fletcher's family expressed regret.
"We had hoped that the latest turn of events would finally lead to some closure for the family," they said.
The killing of a woman police constable caused deep public revulsion and sparked an 11-day standoff with police outside the embassy, officially referred to as the Libyan People's Bureau.
In 1999, Libya accepted "general responsibility" for Fletcher's death.