MPs from her Christian Democrat party (CDU) rejected her chosen candidate as their parliamentary leader and voted instead for a challenger who had promised to be more independent.
The defeat, her first since taking power, was a body blow to Mrs Merkel’s authority and leaves her facing a backbench rebellion as she tries to get her coalition’s legislative programme through parliament.
Conceding her nominee had lost she said: “This is an hour of democracy, and it has its defeats. There is nothing to gloss over.”
Thomas Oppermann, a senior MP from her coalition partner, the Social Democrats (SPD), described the result as “an uprising against Merkel”.
Opposition MPs seized on the defeat as a clear sign that her grip on power was diminishing.
Niema Movassat of The Left Party said: “This is the beginning of the end for Merkel. Her authority is massively damaged.”
Alice Weidel of the nationalist Alternative for Germany party said: “The defeat of Volker Kauder makes Angela Merkel’s loss of power in the CDU clear.
“The twilight of Merkel has finally begun.”
Mrs Merkel had nominated Volker Kauder, an arch-loyalist who has served her as parliamentary leader for 13 years for re-election, and her choice was endorsed by the rest of the party leadership.
But the 69-year-old Mr Kauder was defeated by Ralph Brinkhaus, a relative unknown who said he was standing as the candidate of change, to renew the party.
Mrs Merkel has failed to stamp her authority on the Grand Coalition government and has suffered a bruising summer of power struggles with CSU leader Horst Seehofer.
This culminated in last night’s shock defeat which had previously been considered unthinkable.
Some MPs were expected to rebel in a protest vote against Mr Kauder but most forecasts predicted the challenger could hope for 30 per cent at most.
In the end, Mr Brinkhaus won with 125 votes to Mr Kauder’s 112. Two MPs abstained.
The result calls into question Mrs Merkel’s ability to get legislation through parliament as her 45-seat majority could easily by overturned by a a similar rebellion within her own party.