Die Heimat, known until 2023 as the NPD, was "excluded from state funding for a period of six years", the court said.
Markus Söder could be a "blueprint for the AfD" -- an idea which has its supporters across the political spectrum.
In its reasoning, the court said Homeland sought to "eliminate the free democratic order" and had a "racist, in particular anti-Muslim, anti-Semitic and anti-Gypsy, attitude" that clashed with Germany's constitutional principles.
The neo-Nazi group would therefore lose access to state funding available to parties, as well as any tax breaks.
"The forces that want to dismantle and destroy our democracy must not receive a cent of government funding," Interior Minister Nancy Faeser said.
The court verdict comes amid debate in Germany over how to counter the popularity of the far-right AfD, which is under close surveillance by domestic intelligence after being classed a "suspected case of far-right extremism".
The AfD currently sits second in national polls, and is leading them in several eastern regions where elections are set to be held later this year.
'Confirmed' extremist
The party's rise has tapped into concerns over rising migration, high inflation and a stumbling economy.
The prospect that the AfD is closer to holding high political office than ever before has added urgency to the debate over how to respond.
Below the national party, three regional branches of the AfD -- in the eastern states of Saxony, Saxony-Anhalt and Thuringia -- are classed as "confirmed" extremist organisations for their efforts to undermine democracy and their anti-immigrant rhetoric
Over the weekend, hundreds of thousands of people came out to protest against the AfD after its members were revealed to have discussed a mass deportation plan at a meeting with extremists.
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"This ruling comes at a time which shows again that right-wing extremism is the greatest extremist threat to our democracy -- and to people in our country," Faeser said.
The mooted mass deportation plan was "an attack on the foundations of our society", Faeser said.
Germany's democratic institutions would make use of the "instruments" available to them, she said.
Some government figures have urged caution, however, and warned against giving the AfD material for an anti-establishment campaign.
Failed ban
The challenge to the AfD needed to be "political", while any action should be limited to the "constitutionally necessary and possible", Finance Minister Christian Lindner told broadcaster Welt TV.
The parties of the "democratic centre" should not give the impression they "want to use party law to fend off unwanted competition", Lindner said.
The request to exclude Homeland from state financing was made by the German government, together with the upper and lower houses of the German parliament in 2019.
A previous attempt to ban the party outright in 2017 failed, when the constitutional court in Karlsruhe said the then NPD was not a real enough threat to be prohibited.
The German constitution was subsequently changed to introduce the possibility of withdrawing state funds.
Public money flows to any party in Germany which scores at least 0.5 percent in national or European elections, or one percent in regional votes.
Homeland, which as the NPD was for a long time a small but significant minority party, has seen its following dwindle and has dropped below the support threshold to be eligible for public funds.
But the party has still benefitted from tax advantages available to political parties, such as exemptions for donations.
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