The art trove was found in the Munich home of 81-year-old Cornelius Gurlitt in 2012 by authorities investigating him for tax fraud. Of the 1,280 works they confiscated, around 500 are suspected of being looted by the Nazis.
In response to a complaint filed by his lawyers, investigators in Augsburg said on Wednesday they would return the paintings to Gurlitt.
Prosecutors said there had been new findings in the investigation and on Monday Gurlitt agreed to let art experts investigate the works and return any to their rightful owners.
But Bavarian justice minister Winfried Bausback claimed on Wednesday that there was "no deal".
"I've said from the beginning," he said.
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The works, whose value has been estimated at hundreds of millions of dollars, were seized in February 2012 when they were discovered by chance in the course of a small-scale tax evasion investigation.
Experts have questioned the legality of the seizure order, calling it vastly disproportionate.
Prosecutors said the tax probe would nevertheless continue.
Gurlitt's father Hildebrand acquired most of the paintings in the 1930s and 1940s, when he worked as an art dealer tasked by the Nazis with selling works stolen from Jewish families and avant-garde art seized from German museums that the Hitler regime deemed "degenerate".
The case only came to public attention when Focus news weekly published an article on it late last year, sparking fierce international criticism that German authorities kept the case under wraps for so long.
Gurlitt's lawyer Tido Park told AFP he welcomed the decision to release the works but sharply criticized "egregious flaws" in the initial order to seize the collection.
"The restoration of (Gurlitt's) reputation is strengthened by today's decision," he said.
Under this week's accord, a government-appointed international task force of art experts will have one year to investigate the provenance of all the works in Gurlitt's Munich collection.
Artworks subject to ownership claims after that deadline will be held by a trust until the cases are resolved.
Gurlitt will be able to keep the remaining works, which are being held at an unknown location.
German officials have expressed hope he will lend or donate them to a museum.
Gurlitt had said in a media interview earlier this year that he had no intention of giving artworks to potential claimants.
But the elderly recluse, who is suffering from a number of health problems, has subsequently taken on a new team of advisors and appears keen to burnish his personal legacy.