The German chancellor, who came to London on Wednesday for talks with the prime minister, has been fiercely opposed to his idea of an "emergency brake" that could be applied to EU migrants in order to curb the amount of people coming.
Cameron was going to reveal his plan in a keynote speech on immigration last November, but ditched it reportedly 48 hours before he gave the speech, sources told the Daily Mail.
Merkel is reported to have told the Prime Minister that she would back his proposals for curbs on migrants' access to benefits, however she warned him that she was prepared to let Britain leave the EU rather than allow him to cap the number of EU migrants by changing the European principle of free movement.
The Prime Minister used his speech to set out a range of measures to limit benefits for migrants, promising to block European arrivals from claiming welfare for the first four years after they arrive in Britain, instead of the mooted emergency controls.
Ukip leader Nigel Farage poured scorn on the news, writing on Twitter: "Remind me who makes UK government policy again?"
Ukip's immigration spokesman Steven Woolfe told the Huffington Post UK: "This shows clearly that the UK and the rest of the European Union dance to Germany's tune.
"While the Prime Minister enjoys talking with a back bone on tackling EU migration when pressured by the success of UKIP, in reality he is powerless in standing up for the best interests of the UK in the face of Merkel's intransigence.
"Until David Cameron adopts UKIP's policy of withdrawing from the EU and negotiating fair and ethical migration controls with other EU countries on our way out, he will doom the UK to more failures caused by global flows of mass migration."
Senior Tory eurosceptic Sir Bill Cash warned that Britain would fail to reduce the level of EU migration without imposing a cap on numbers.
"Our economy is doing pretty well, and actually that means more people are going to come in. Therefore the cap is really the key question, and if you don’ t have a cap then it won’t work… unfortunately that seems to have been abandoned," he said.
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Foreign secretary Philip Hammond has vehemently denied that Cameron bowed to pressure from Merkel to drop his "emergency brake", although he acknowledged that ministers had consulted with other EU member states.
Speaking to the BBC Radio 4's Today programme in November, he said: “I don’t think that is right. What is right is that we have sought to work with our partners in the European Union to understand the best way of delivering a reduction in immigration numbers from the EU in to the UK."
Merkel said at the time: “The German government has in the past again and again underlined the significance of the principle of the free movement as it is anchored in the EU treaties. It is important that Cameron commits himself to this central pillar of the EU and the single market.”
This comes as Cameron's pledge to cut net migration to the "tens of thousands" by next May looks increasingly likely to fail.
Recent figures from the Office of National Statistics found that the figure, charting the increase of new arrivals over those leaving the country, rose to 243,000 in the year to March in a "statistically significant increase".
This has led experts to conclude that ministers should drop their "now meaningless" pledge to reduce net migration to the tens of thousands "without severely harming the economy".
Mark Hilton, head of immigration policy at non-profit organisation London First, said the net migration target must be "put out of its misery".
Carlos Vargas-Silva, senior researcher at the Migration Observatory at Oxford University, said: "Net migration has increased again, and is now close to the levels when the current Government took office, suggesting that the Government's net migration target of under 100,000 is now effectively impossible to hit.
"The UK's comparatively strong economic growth is attracting EU nationals, who have a right to live and work in the UK, to the British labour market - a very important factor in this increase."