"Mr Maassen will become state secretary in the interior ministry," Merkel and the leaders of her coalition parties announced in a statement after crisis talks.
The face-saving compromise lets Merkel's fourth-term government live to see another day, after her Social Democratic coalition partners had insisted on Maassen's departure as head of the BfV intelligence service, against the wishes of Interior Minister Horst Seehofer from her Bavarian CSU sister party.
Maassen, 55, was at the centre of a heated controversy after he raised doubts about the veracity of reports of far-right hooligans and neo-Nazis randomly attacking immigrants in the eastern city of Chemnitz in late August.
In his senior new role, essentially a promotion, Maassen will not be responsible for supervising the Federal Office for the Protection of the Constitution (BfV), the party leaders stressed in their statement.
German far-right protesters clash with leftists after Chemnitz stabbing
The far-right attacks in Chemnitz, which caused revulsion in Germany, were triggered by the fatal stabbing of a German man over which police are holding a Syrian suspect and searching for an Iraqi man. A court freed another initial Iraqi suspect on Tuesday.
Days after the unrest, Maassen questioned the authenticity of amateur video footage showing street violence and voiced doubt that racists had indeed "hunted down" foreigners — comments that directly contradicted Merkel, who had deplored the xenophobic attacks and "hatred in the streets".
SPD leaders—as well as the opposition Greens, Free Democrats and Linke parties — had demanded the resignation or sacking of the spy chief for political meddling, and pointed to his repeated meetings with leaders of the anti-immigration Alternative for Germany (AfD) party.
Whatever Maassen's true political leanings, the issue has turned him into a martyr of Merkel haters and the far right.
The AfD's Alice Weidel wrote on Facebook that "anyone who criticises Merkel's illegal immigration policy is mercilessly put through the wringer by the mainstream parties".
Far-right makes most noise on Twitter in German election
Maassen has rejected accusations that he has supported AfD lawmakers with early access to unpublished data and advice on how to avoid surveillance by his office.
Social Democrat leader Andrea Nahles had charged that Maassen had "provided material for right-wing conspiracy theorists".
However, Maassen had the backing of his immediate boss, the CSU's hardline Interior Minister Seehofer, who has for three years been Merkel's nemesis within the ruling grand coalition.
Seehofer, a harsh critic of Merkel's 2015 decision to allow a mass influx of migrants and refugees, had in July brought the government to the brink of collapse with his threat to shutter national borders to asylum seekers.
With that bitter dispute barely papered over, the conflict over Maassen's fate once more highlighted the deep chasms within Merkel's coalition.
On one level, both major parties, the CDU and SPD, are distrustful partners stuck in a political marriage of convenience after the AfD, a one-time fringe party, poached millions of their voters in last year's elections.
But the rift is deepest between Merkel and Seehofer, whose own political future hangs in the balance as his CSU braces for potentially massive losses to the AfD in Bavarian state elections next month.
Seehofer recently labelled the migration issue "the mother of all problems" in German politics — a comment read by many as a veiled reference to Merkel's nickname "Mutti", or Mummy.
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