A failure from the political leader to form a new Government could launch a leadership challenge against Mrs Merkel.
The country has been without a Government for almost two months after the general election on September 24 produced a hung parliament.
“It is better not to govern than to govern badly.”
The collapse of the negotiations comes after the parties missed their deadline of 6pm on Sunday evening, one of several self-imposed deadlines to have been missed.
There are fears Mrs Merkel could face a snap election following her failure to form a new Government with the support of the other parties.
Wolfgang Kubicki, FDP vice president, had earlier warned: “If we don’t work it out by 6pm on Sunday, the whole thing is dead.”
That deadline was then extended to midnight following the inability to agree on a deal, but the FDP’s walk out from the talks means no deal was reached.
The crunch talks are widely seen as the biggest test of Mrs Merkel’s Chancellorship in her 12 years in office and failure to form a Government could mark the end of her political career.
Meanwhile, there have been warnings that the deadlock in Germany’s talks will have a knock-on effect on the EU.
The EU’s Budget Commissioner Guenther Oettinger has warned that the block will be “damaged” by Mrs Merkel’s inability to form a Government.
He said a failure to reach a deal would “damage Europe and strengthen the region’s populists” as the bloc waits for its economic powerhouse to form a government.
Speaking to RT, Werner Patzelt, a political scientist and CDU party member, said that Europe will be stuck while German political parties continue to negotiate.
He said: “Germany is the most important power of EU, the EU cannot move without Germany. Decisions will have to be on hold.
“For Germany to push forward the EU, they need a stable government, so all European business has to wait until the Germany is ready to be an active player in the EU game.
“Germany has paralysed itself, which is exceptional. Merkel contributed to this, so it is up to her to find a way through.”