Polish Prime Minister Donald Tusk last year personally lobbied Merkel to ditch Erika Steinbach. One Polish magazine has caricatured her in Nazi uniform.
The row over Steinbach, head of the League of Expellees, has also caused rifts in conservative Merkel's coalition with the Free Democrats (FDP).
The German government yesterday (11 February) reached a compromise with the League, which represents the interests of 12.5 million Germans expelled from Poland and other parts of Eastern Europe after the defeat of the Nazis in World War Two.
Steinbach, a prominent lawmaker in Merkel's party, is a figure of hate in Poland because of her forceful promotion of the interests of expellees and her decision to vote against recognising Germany's border with Poland in the early 1990s.
After the war, Poland's borders were shifted west by international treaty and German communities were forced to leave their homes in Poland, Hungary and what was then Czechoslovakia.
Poles say they fear attempts to portray Germans as victims of a war they started and that the new museum will give a biased view.
Steinbach said she was happy to stand aside from the museum job as other demands put forward by her League had been met.
"I would certainly not let myself be nominated now," Steinbach told reporters. "I am very happy with what we have achieved. There are neither winners nor losers."
Under the compromise, the Bundestag lower house of parliament, rather than the German cabinet, will have the right to veto the make-up of the museum's board.
The League will get more seats on the board and the museum will be bigger. Parliament has to vote on a law to approve the new plans.
FDP chief Guido Westerwelle, who had opposed the planned appointment of Steinbach as he wanted to avoid incensing Warsaw, said he was happy with the deal.
"That the German parliament will choose members of the museum board guarantees respect for our foreign policy interests and creates transparency," Westerwelle said in a statement.
The matter had been a headache for Merkel because Steinbach wields influence over a large number of her conservative Christian Democrats.
(EurActiv with Reuters.)
