The Social Democrats (SPD) and Greens won by a single seat after a close race for power in Germany's fourth most populous state. Merkel's Christian Democrats (CDU) lost ground but their Free Democrat (FDP) allies defied forecasts that they would be ejected from the state assembly in Hanover.
"A one-vote majority can be very stable," said Stephan Weil, Hanover mayor and SPD state premier candidate after a nail-biting six-hour wait for results that were long too close to call.
The outcome will be a setback for Merkel, but the 58-year-old chancellor still enjoys high personal popularity for her leadership role in the euro crisis where she defended Germany's economic interests. She might also cite the success of the FDP as a good omen for September polls she hopes will return her center-right coalition.
The SPD had been dreading the results, their own candidate for chancellor, Peer Steinbrück, struggling to rally support after a series of gaffes.
Steinbrück acknowledged "shared responsibility" for a patchy campaign in Lower Saxony, a major agricultural and industrial centre, but said the result proved that the SPD was clearly still in the race for September.
"This means a change of government and of power are possible this year," said Steinbrück.
SPD chairman Sigmar Gabriel - a former state premier of Lower Saxony himself - said with a smile: "If we get a result like this when we mess up, we can do anything."
The SPD and Greens won 46.3% against 45.9% for the CDU and their Free Democrat partners - who easily cleared the five percent hurdle to enter the assembly with a vote of 9.9% - twice what had been expected.
The CDU remained the biggest party in the swing state but suffered their 13th local election setback in a row - and lost their fifth state government to the SPD since 2009.
The result was an anti-climax for David McAllister, the half-Scottish state premier who has been spoken about as a potential successor to Merkel when the opinion polls were still predicting a win for the CDU.
His colourful campaign - complete with bagpipes and seven personal appearances from Merkel - was not enough to stop the CDU dropping six percentage points from the last election in a state where its standing was damaged by the previous premier.
But the surprise of the contest was the FDP. Mirroring its decline on the federal stage, it had been thought the FDP would be lucky to keep a seat in the state assembly in Hanover.
Its tendency to prove the pollsters wrong in state votes may give Merkel hope for the September elections, when she wants to renew the centre-right coalition rather than seek a 'grand coalition' with the SPD, as she did in 2005-2009.
FDP leader and economy minister Philipp Rösler will have won a reprieve from calls for him to step down.
But the unspoken strategy in the Lower Saxony vote of quietly encouraging CDU voters to split their ballot - one for their own constituency candidate and one for the party - to save the FDP's hide appeared to have backfired for Merkel's party.
"What is astonishing is that it looks like the CDU had a hidden campaign to get voters to use their second vote for the FDP so they could hold on to power," said politics professor Gero Neugebauer at Berlin's Free University.
"Yet the FDP didn't pick up all the votes lost to the CDU. As a whole the centre-right bloc lost support in Lower Saxony."