The controversy has sparked the second major stress test for a weakened Merkel's fourth-term government forged half a year ago between her centre-right CDU, its conservative Bavarian sister party CSU and the centre-left Social Democrats (SPD).
The three party chiefs last week huddled to discuss the fate of Hans-Georg Maassen, head of the BfV intelligence service -- but postponed the tricky issue until a new crisis meeting scheduled for 1400 GMT Tuesday.
Maassen, 55, became the focus of heated controversy after he raised doubts about the veracity of reports about far-right hooligans and neo-Nazis randomly attacking immigrants in the eastern city of Chemnitz in late August.
The attacks, which sparked revulsion in Germany and abroad, were sparked by a fatal stabbing in which an Iraqi was identified as the chief suspect.
Days later, Maassen questioned the authenticity of amateur video footage showing the mob 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 -- have since 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 quickly 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".
Deep chasms
Maassen has rejected accusations that he has supported AfD lawmakers with early access to unpublished data and advice on how to avoid surveillance by his Federal Office for the Protection of the Constitution (BfV).
Social Democrat leader Andrea Nahles has insisted Maassen must go and SPD youth wing leader Kevin Kuehnert, 29, mockingly tweeted that he should either explain his conspiracy theory or "throw in his tin foil hat".
However, Maassen has received the backing of his immediate boss, the CSU's hardline Interior Minister Horst 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 highlights 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.
'Mother of all problems'
Last week Seehofer 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.
Die Welt daily reported Monday that Merkel had now decided to let Maassen go, quoting unnamed coalition sources.
According to the newspaper, this could have wider political ramifications: Maassen had reportedly told a closed-door meeting of conservative lawmakers that "Horst Seehofer told me that if I fall, he falls too".
Merkel and Seehofer have not commented publicly, other than to insist that the coalition will not break up over the issue.
Amid the controversy, business daily Handelsblatt commented that the renewed political "arguing, brawling and fighting" raised the question of "how long will this government, which has only been in office for half a year, last?"
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