"The request has been rejected," said Federal Constitutional Court top judge Andreas Vosskuhle about the bid to ban the neo-Nazi party, which has around 6,000 members.
He added that "the NPD pursues anti-constitutional goals, but there is currently no concrete evidence... to suggest that it will succeed."
The case marks the second failed attempt to outlaw the National Democratic Party of Germany, with the latest launched by the Bundesrat upper house of parliament which represents Germany's 16 states.
Chancellor Angela Merkel's government supported the case, although the executive did not formally join the high-stakes legal manoeuvre.
The Bundesrat had launched the challenge in 2013, as the country was reeling in shock over the 2011 discovery of a murderous group calling itself the National Socialist Underground.
Racist killings by the group had prompted Germany to crack down against right-wing extremism.
But since then, the NPD has lost its remaining seats in state parliaments, retaining just one representative, Udo Voigt, in the European Parliament.
It has also lost ground to the anti-euro fringe party AfD, which has morphed into an anti-immigration force railing against the mass arrivals of refugees in 2015.
Polls now credit the NPD with around 1.0 percent support, compared with 12 to 15 percent for the right-wing populist AfD (Alternative for Germany).
High hurdles for ban
But the International Auschwitz Committee's vice president Christoph Heubner voiced dismay at the ruling, warning that it could spur extremists across Europe to champion more hate.
"How can it be that those who cheerfully celebrate the Holocaust and provoke new episodes of hatred in many municipalities may remain in the democratic spectrum?" he asked.
"This reality-blind and untimely decision sends a disastrous signal to Europe, where far-right and right-wing populists have found new partnerships and are now trying to transform the fear and insecurity of the population into hatred and aggression," he warned in a statement.
For the court, "banning a party does not equate to banning an ethos or a world view."
"The party's battle against the democratic order would need to surpass a threshold" to warrant prohibition, said Vosskuhle, the Constitutional Court top judge.
"There must be a systematic approach aimed at destroying or eliminating the liberal democratic constitution or threatening the existence of Germany," he said, noting that the threat had to be credible.
With an eye cast back at the elimination of dissent in Hitler's Germany, the drafters of the post-war constitution set high hurdles for banning a party.
Only two political parties have been outlawed since 1945: the SRP, a Nazi successor party, in 1952, and the West German Communist Party (KPD) in 1956.
'Germany for Germans'
Founded in 1964 as a successor to the neo-fascist German Reich Party, the NPD calls for "the survival and continued existence of the German people in its ancestral central European living space" - or simply, "Germany for the Germans".
Such language flirts with the turns of phrase used by the Nazis.
For the Bundesrat, the group creates a "climate of fear", "shares essential characteristics" with the Nazis and "wants to destabilise and overthrow the liberal-democratic order".
Germany's domestic intelligence services classify the ultra-nationalist NPD as a far-right party.
Things however have changed in German politics since the launch of the second case against the NPD in 2013.
The AfD has brushed the NPD to the fringes, and the populist movement could see members elected to the parliament in Berlin at polls later this year - something no similar party has managed since 1945.
Many politicians and media commentators say parties such as the NPD must be beaten in the battle of ideas.
"It's up to politics and civil society, not the courts," the centre-left Süddeutsche Zeitung daily commented.
"Hating foreigners cannot be banned, no law can help against radicalisation reaching the centre of society."
What's more, the newspaper argued, banning the NPD risked sending a signal to "autocrats" abroad, who could point to the decision to justify crushing the opposition.