Investigating magistrates have ordered the case against the 64-year-old sociology professor to be dropped against the advice of public prosecutors, who last year called for it to go to trial, sources told the AFP news agency on Friday.
The magistrates found the evidence against him inconclusive.
Diab was the only suspect in the 1980 bombing of a synagogue in Paris's rue Copernic that killed four people and injured about 40.
Although responsibility for the attack was never claimed, the investigation attributed it to a breakaway faction of the Popular Front for the Liberation of Palestine, the PFLP-SO.
Denied being in Paris
French secret services identified Diab as the bomber in 1999 and other evidence, including a handwriting test and an identikit picture, was cited in support of that theory.
He was arrested in Canada on a French request in 2008 and, while predicting that a conviction were unlikely, a Canadian judge ordered his extradition in 2011.
After a series of appeals he was finally brought to France in 2014.
Diab claims to have been taking exams in Beirut at the time.
University documents and testimony from several students corroborated his version, according to the magistrates.
They criticised evidence provided by French and Israeli secret services for being "full of contradictions and imprecision" and said another suspect, who was never investigated, bore as much if not more resemblance to the indentikit as Diab.
The magistrates also noted that his fingerprints were not among the several found on objects that may have been handled by the perpetrators.
Magistrates oppose prosecutors
While admitting there were serious doubts about Diab's guilt, the public prosecutors' office believed a court should decide on the evidence.
The magistrates had already clashed with the prosecutors over the suspect's detention.
They several times called for him to be released and placed under house arrest under electronic surveillance but were overruled when the prosecutors appealed.
Last year a group of Canadian artists, activists and politicians, including filmmakers Atom Egoyan and political activist Naomi Klein, urged Canadian Prime Minister Justin Trudeau to intervene to secure his release.