It ruled that Hartmut Hopp, 74, could not be jailed because the evidence the Chilean court had provided against him fell short of that required under German judicial standards.
Hopp was a doctor in the notorious "Colonia Dignidad" sect that abused members and was used as a place to torture and "disappear" regime critics during the 1973-1990 dictatorship of Augusto Pinochet.
The German doctor was the right-hand man of convicted paedophile Paul Schäfer a former Wehrmacht soldier and lay preacher who in 1961 founded the commune that indoctrinated residents and kept them as virtual slaves.
Hopp was convicted in Chile of crimes including complicity in Schäfer's rape and sexual abuse of minors but in 2011 fled to Germany before the final court ruling was imposed.
Berlin declined to extradite the German citizen, but a lower court in the city of Krefeld in August 2017 upheld the Chilean court's jail term of five years and one day, in a ruling cheered by human rights groups.
But that ruling has now been overturned by a higher court in Düsseldorf, which found that the evidence provided by the Chilean court fell short of that demanded by German justice.
'Great pain'
The court said that it had to ascertain "whether the findings of fact made in the Chilean judgements are sufficient to justify criminal liability under German law".
"This is not the case in the view of the court," it said in a statement on the ruling it reached last Thursday, adding that the appeal decision was final.
It said it had found no concrete evidence in the Chilean rulings that Hopp, who ran the compound's clinic, had actively aided and abetted the abuses committed by Schäfer, who ran its boarding school.
German Greens party politician Renate Künast voiced dismay at the latest ruling on Hopp, saying that "this decision will cause great pain for many victims of Colonia Dignidad".
Most of them were "traumatised by their time in the Colonia, which for many meant sexual violence, electric shocks and daily repression", she said.
While many of the now elderly victims were living in poverty, Künast said, "the doctor of Colonia, who was part of the repressive system, fled the justice system for Germany".
The scale of the atrocities committed at the fenced-in 13,000-hectare mountain commune some 350 kilometres south of Santiago came to light only after the end of Pinochet's regime.
The abuses at the sect were the subject of the 2015 movie "The Colony" starring Emma Watson and Daniel Brühl.
Schäfer had in 1997 faced a series of lawsuits and fled Chile. He was arrested in Argentina in 2005 and convicted in Chile the following year for sexual abuse of children, weapons possession and human rights violations.
He died in a Chilean jail in 2010 at the age of 88 while serving a 20-year sentence.
Germany in 2016 said it was declassifying its files on the sect, and the foreign minister at the time, Frank-Walter Steinmeier, admitted that "from the 60s to the 80s, German diplomats looked the other way, and did too little to protect" the German citizens living in the sect.
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