The boards of the two companies concluded the merger "cannot be implemented within the time frame provided" due to legal proceedings against Porsche in Germany and the United States for alleged market manipulation, Volkswagen said in a statement.
"Nevertheless, all parties remain committed to the goal of creating an integrated automotive group with Porsche and are convinced that this will take place," it added.
Luxury sports car firm Porsche stunned the auto manufacturing world in October 2008 when it announced that it had acquired 75 percent of Volkswagen. But the takeover move backfired against the backdrop of the financial crisis as Porsche racked up a €9-billion debt in acquiring a controlling stake in Europe's largest carmaker, and it was Volkswagen that saved the sports car company.
However, their merger plans have been frustrated by lawsuits by investors against the maker of 911 sports cars for allegedly causing them to suffer several billion dollars in losses as a result of misleading comments on Porsche's intentions to take over VW.
Volkswagen said the legal proceedings "mean that it is currently impossible to quantify the economic risks of a merger and therefore to perform the valuation of Porsche SE required to determine the exchange ratio."
Porsche said in its statement that allegations in the lawsuits are "unfounded."
It added that the the delay in the merger would force it to book significant writedowns on financial assets that would push it into the red over the first three quarters of the year. Porsche had booked a net profit of €149 million in the first half of the year. Despite the accounting setback Porsche spoke of a "continuing positive evolution" of its business.
Volkswagen, on the other hand, said a reevalution of the value of stock options due to the delay in the merger "is expected to lead to a clearly positive contribution to Volkswagen AGs financial result." The company posted a profit of €6.2 billion in the first six months of the year.
Volkswagen said over the coming weeks its management board would look at other possible ways of merging with Porsche other than via stock options as set out in their current agreement.