The xenophobic Alternative for Germany (AfD) clinched 21 percent in its first bid for seats in the regional parliament of Mecklenburg-Western Pomerania, results showed after most ballots had been counted from Sunday polls.
Merkel's conservative Christian Democratic Union (CDU) garnered just 19 percent in its worst ever score in the northeastern state, while the Social Democrats maintained top place with around 30 percent.
AfD's lead candidate Leif-Erik Holm called it a “proud result for a young party” as the populists secured seats on the opposition benches of the ninth out of 16 regional parliaments.
“The icing on the cake is that we have left Merkel's CDU behind us… maybe that is the beginning of the end of Merkel's time as chancellor,” he said.
Although the former Communist state is Germany's poorest and least populous, it carries a symbolic meaning as it is home to Merkel's constituency Stralsund.
Together with Berlin's elections in two weeks, Sunday's polls are a key test ahead of general elections next year, when Merkel's decision exactly one year ago to let in tens of thousands of Syrian and other migrants is expected to be a key point of contention.
Although she won praise at first, the optimism has given way to fears over how Europe's biggest economy will manage to integrate the one million people who arrived last year alone.
Merkel's decision has left her increasingly isolated in Europe, and exposed her to heavy criticism at home, including from her own conservative allies.
The CDU's general secretary Peter Tauber said Sunday's results were “bitter”, acknowledging that voters “wanted to send a signal of protest, as we had noticed in discussions about refugees”.
'No money for us'
In the sprawling farming and coastal state of Mecklenburg-Western Pomerania, where economic regeneration and jobs used to be residents' top concerns, the issue of refugees and integration has become the deciding factor for one in two voters.
“There was only one issue, that is, and was, refugee policy,” said the CDU's main candidate Lorenz Caffier.
A pensioner and former teacher who declined to be named said he picked the AfD because of the “question over asylum-seekers”.
“One a million refugees have come here. There is money for them, but no money to bring pensions in the east to the same levels as those of the west,” he said, referring to the lower retirement payments that residents of former Communist states receive compared to those in the west.
Compared to other parts of Germany, the northeastern state hosts just a small proportion of migrants under a quota system based on states' income and population – having taken in 25,000 asylum seekers last year.
Most of them have already decided to abandon the state, preferring to head “where there are jobs, people and shops,” said Frieder Weinhold, CDU candidate.
But the “migration policy has sparked a feeling of insecurity among the people,” he said.
After a series of attacks by asylum-seekers in July – including two claimed by the Islamic State group – the mood has also darkened.
Conservative daily Die Welt commented: “Germany now has what has never existed since the end of the war: an extreme-right party”.
The AfD, which was founded in 2013, has continued its meteoric rise even though leading members of the party have sparked outrage over insulting remarks, including one disparaging footballer Jerome Boateng, of mixed German and Ghanaian descent, as the neighbour no German wants.
Its latest achievement was hailed by French far-right leader Marine Le Pen, who wrote on Twitter: “What was impossible yesterday has become possible: the AfD patriots have swept away Merkel's party!”
Ahead of Sunday's vote, Merkel, who is attending the G20 summit in the Chinese city of Hangzhou, had urged voters to reject the populists.
“The more the people who go to vote, the less the percentage won by some parties that, in my view, have no solution for problems and which are built mainly around a protest – often with hate,” she said.