In one of the tightest state races in recent memory, the Social Democrats and the Greens Sunday eked out a one-seat majority in Lower Saxony over the incumbent coalition of Merkel's Christian Democrats with the Free Democrats.
After a suspense-packed night with broad implications for the September general election, the centre-left camp said it aimed to use its victory to create fresh momentum in its bid to deprive Merkel of a third four-year term.
She was said to be planning to meet her party and hold a news conference on Monday morning.
"It shows the race until September is far from over," the Social Democrats' embattled challenger to Merkel, Peer Steinbrück, said.
Merkel, who campaigned hard for state premier David McAllister, a half-Scot widely seen as a potential successor to her, enjoys a strong lead in national polls due to her fierce defence of German interests in the eurozone crisis.
But pundits said the state win could help shore up the battered campaign of the gaffe-prone Steinbrück.
After a series of regional poll setbacks, Merkel's Christian Democrats (CDU) lost support in Lower Saxony but remained the strongest party with 36 percent of the vote.
Their state coalition partners for the last decade, the pro-business Free Democrats (FDP), drew nearly 10 percent -- more than doubling many pollsters' forecasts and their best result in Lower Saxony in post-war history.
But their cumulative result fell just short of the Social Democrats (SPD) at around 33 percent with the Greens' 14 percent, meaning the opposition can build a one-seat majority to govern Germany's fourth most populous state.
The FDP, Merkel's junior partner in government since 2009, got a lift from CDU voters splitting their ballots under Germany's two-vote system in a bid to rescue the coalition.
Around 101,000 voters who backed the conservatives in 2008 had plumped for the FDP this time.
Some 6.2 million people were called to the polls in the north-western state home to auto giant Volkswagen.
If the FDP had failed to win representation, its embattled leader Philipp Rösler, who is also Merkel's vice chancellor and economy minister and who hails from Lower Saxony, would likely have been forced to step down.
The outcome seemed to grant him a reprieve.
"It is a great day for the FDP in Lower Saxony but it is also a great day for the FDP and liberals in Germany as a whole," a beaming Rösler told reporters.
The Morgenpost newspaper said there were a number of lessons to draw from the vote.
"The CDU is not as strong as it feels. The FDP is not as dead as it looks. And a continuation of the black-yellow coalition in Berlin is no longer so unthinkable," it wrote, referring to Merkel's team.
"The only thing that is sure is that it will be tight."
The centre-left Süddeutsche Zeitung said the election may grant both the flailing FDP and the beleaguered Social Democrats a new lease of life.
"The FDP now has time to recover, to sort itself out," it wrote, noting it was still fighting for survival with dismal national poll ratings. "The SPD has the same task ahead."
Steinbrück, a former finance minister from Merkel's 2005-09 "grand coalition" government, was anointed by the SPD as its chancellor candidate late last year.
But he has run into trouble with revelations that he made around €1.25 million over the last three years in speaking fees, and with comments suggesting that Merkel owed much of her popularity to her gender.
Despite the narrow win, Steinbrück admitted he had been of little help to his party in the key poll.
"The Social Democrats did not have tailwinds from Berlin," he said. "I share a significant part of the responsibility."
After Lower Saxony, only the southern state of Bavaria is expected to vote before the general election.