The court in Würzburg ruled that the US social media giant is not obliged to actively search out and delete defamatory posts, like those that had falsely linked the claimant, Anas Modamani, 19, to Islamist attacks and violent crimes.
Modamani wanted the US social media giant, represented by Facebook Ireland Limited, to stop the spread of such defamatory fake news, which have been shared countless times.
He was represented by German lawyer Chan-jo Jun, who has previously launched legal action against Facebook, demanding it stop the spread of racist hate speech and other content illegal under German law.
"It must become more costly to break the law," the lawyer tweeted ahead of the court ruling.
Modamani and Jun had demanded Facebook actively search out and take down all slanderous posts using the famous selfie images - not just those they have flagged to the company.
Facebook lawyers have argued this would require a "miracle machine" that had not yet been invented, said Jun.
But the lawyer had countered that Facebook can automatically identify and take down, for example, copyrighted music and pornography.
The court found it was unclear whether Facebook could indeed conduct such pro-active searches "without major technical hurdles", and said this question may have to be settled by another court in the future.
Modamani arrived in Germany in 2015, along with tens of thousands of other refugees and migrants.
When Merkel visited his Berlin refugee shelter in September that year, he took two selfie images with her in jubilant scenes also captured by news photographers.
Since then, those images have been reposted in different contexts countless times, as right-wing fury has flared online against Merkel's liberal stance on refugees.
Users have cut and pasted Modamani's picture into "wanted" posters and on fake news reports, typically alleging that the refugee made famous by the Merkel selfie had later turned out to be a terrorist.
Modamani, who is now taking German language courses and working in a fast food restaurant, said the hateful posts had had a damaging impact on his life.
Asked about the case, Facebook has told AFP it is "committed to meeting our obligations under German law in relation to content which is shared by people on our platform".
The company and other web giants pledged in December 2015 to examine and remove within 24 hours any hateful comments spreading online in Germany, in particular over the mass influx of 890,000 migrants that year.
Jun last year launched legal action against Facebook in a Munich court, accusing its executives of condoning incitement of hate and violence.
Justice Minister Heiko Maas, who has been negotiating with social network chiefs, has also warned that Facebook and others could be punished if they do not comply with German law.
In January, in the wake of the US presidential election when Facebook was attacked for its role in the spread of fake news, the company announced it would introduce measures to take down "unambiguously wrong reports" being shared on its platform.
It said it would offer a simpler reporting process for users to flag suspected fake news, display warnings next to statements identified as false by independent fact-checking organisations, and cut off advertising revenue to fake news sites.