"Suspicions of an unconventional explosive device have been confirmed," police in Brandenburg state outside Berlin said on Twitter.
Police said at 5.36 pm that they had successfully deactivated the bomb.
The Christmas market in the city centre of Potsdam was evacuated on Friday afternoon, as were several businesses in the area. Potsdam is a picturesque city near Berlin that was once a residence for the kings of Prussia.
The packet containing the explosives was found in front of a pharmacy. Police said a pharmacist had sounded the alert after finding a can with wires inside the package.
The worst Islamist terror attack to hit Germany occurred at a Christmas market in Berlin in December last year when a Tunisian man hijacked a truck and drove it into the Breitscheidplatz Christmas market. Twelve people died in the attack which was later claimed by Isis.
Germany has since been targeted again in attacks with radical Islamist motives.
In July 2017, a 26-year-old Palestinian asylum seeker wielding a knife stormed into a supermarket in the northern port city of Hamburg, killing one person and wounding six others before being detained by passers-by.
German prosecutors said the man likely had a "radical Islamist" motive.
And at the end of October, German police arrested a 19-year-old Syrian identified only as Yamen A. suspected of planning a "serious bomb attack" using powerful explosives.
Isis also claimed responsibility for a number of attacks in 2016, including the murder of a teenager in Hamburg, a suicide bombing in the southern city of Ansbach that wounded 15, and an axe attack on a train in Bavaria that left five injured.
Germany remains a target for jihadist groups, according to Isis because of its involvement in the coalition fighting them in Iraq and Syria, and its deployment in Afghanistan since 2001.
German troops in the anti-Isis coalition do not participate in combat operations but support it through reconnaissance, refuelling and training.
Germany's security services estimate there are around 10,000 Islamic radicals in Germany, some 1,600 of whom are suspected of being capable of using violence.
Chancellor Angela Merkel has allowed in more than one million asylum seekers in the past two years - a decision that has driven the rise of the Alternative for Germany (AfD) party, which charges that the influx spells a heightened security risk.