His resignation as defence minister came after two weeks of mounting political pressure for him to quit that in recent days had also seen Merkel come under fire from academics, political allies and the media.
Sources in his party, the Christian Social Union, the Bavarian branch of Merkel's party, said he was also standing down as a member of parliament.
Zu Guttenberg "is someone of outstanding political ability, with a unique and extraordinary ability to reach people's hearts and get them interested in politics," Merkel told reporters after the resignation.
"I am convinced that he will have the strength needed to clear up issues to do with his dissertation ... I am convinced that we will have the opportunity to work together again in the future, in whatever form that may take."
Merkel, whose party suffered a crushing defeat on February 20 at the first of 2011's seven regional elections, had stood by her vote-winning defence minister, saying earlier she "didn't appoint him as a research assistant."
One survey last week even indicated that his popularity had increased since the plagiarism scandal blew up on February 16, with a thumping 73 percent of those questioned happy with his performance.
"This is a huge disaster for the chancellor, who until recently believed that she could navigate her way through this embarrassing affair," the opposition Greens said.
Zu Guttenberg became the most popular figure in Merkel's cabinet since bursting on the scene in 2009, impressing first as economy minister and then at defence and boosting support for Merkel's Christian Democrats (CDU/CSU).
Party rallies ahead of Merkel's re-election in late 2009 saw the nobleman from Bavaria's Franconia region feted like a pop star. He was even touted as a possible successor to Merkel, 56, at the helm of Europe's biggest economy.
"This is a big loss for Angela Merkel," political scientist Gero Neugebauer told AFP. "She is losing an important election campaigner ... Nobody else can excite the same level of interest and excitement."
But he was never a massive hit with the media -- the mass-circulation Bild being a notable exception -- and papers gleefully went on the attack when the accusations he had ripped off others' work first emerged.
The plagiarism row broke after a law professor close to the opposition went through his doctoral thesis and then snowballed as more and more passages were found to be suspect.
Zu Guttenberg, who can trace his family back to the 12th century and whose wife is a direct descendant of the 19th century "Iron Chancellor" Otto von Bismarck, was ridiculed as "Baron Cut-And-Paste" and "Zu Googleberg".
His alma mater, Bayreuth University, withdrew his doctor title last week, with university president Ruediger Bormann saying the thesis was "not the result of correct scientific work".
"We have been taken for a ride by a fraudster," law professor Oliver Lepsius, who succeeded zu Guttenberg's doctoral supervisor at Bayreuth, told the Sueddeutsche Zeitung daily on Saturday.
But Merkel is the "real loser" in this affair, political consultant Michael Spreng said.
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