The auction, scheduled for 20 January, featured Libération front pages modified by 36 artists, among them Ernest Pignon-Ernest, a 76-year-old graffiti-artist.
He had reworked the paper's front page of 12 November 2004, which reported the funeral of the late Palestinian president and PLO leader Yasser Arafat by drawing Barghouti's face on it with the comment "In 1980 when I drew Mandela I was told he was a terrorist".
Barghouti has been in an Israeli jail since 2002.
He is regarded as the leader of the second intifada (2000-2005) and is said to have founded the Palestinian Liberation Organisation's armed wing, Tanzim.
Before becoming South Africa's president in 1994, Mandela served 27 years in a South African jail having been found guilty of leading the African National Congress's armed wing, Umkhonto we Sizwe.
Pignon-Ernest's remark became a self-fulfilling prophesy when Israel's French embassy wrote to Artcurial, demanding that his work be withdrawn.
"This portrait is putting a terrorist project up for auction in seeking to make people believe that it is about a man of peace," the embassy claimed.
It accused Barghouti of being "responsible for the deaths of hundreds of people, Jews and non-Jews".
Artcurial gave in to the embassy's demand, its boss François Tajan declaring that "in the context of the recent terror attacks and the state of emergency" the work was a "potential source of danger the public order".
But Libération and RSF objected to the decision and called off the auction.
"We would like Ernest Pignon-Ernest's work to remain in the sale catalogue ... considering that the purpose of this sale was to support ... freedom of expression around the world," the paper's editor Laurent Joffrin wrote to Artcurial. "To do otherwise would lay ourselves open to reasonable criticism and allow people to believe that we are acting under the influence of an embassy, no matter how respectable."
RSF announced that the partners would seek a different auction house to stage the sale "in order to remain faithful to our principles".
Pignon-Ernest declared himself "astonished that a foreign embassy can decide what one exhibits and that an auction house would give in the pressure".
But he was also amused that the embassy's action may have achieved the opposite of what it intended.
"Not many people know about Barghouti really," he told Le Monde newspaper. "If the Israeli embassy hadn't said anything or got its way nobody would have known about the drawing."
The works have already been on public show, without provoking any noticeable unrest, at Paris's Palais de Tokyo gallery on 12-13 December.
There have been no incidents at an exhibition of photos entitled "Palestinians between two wars" sponsored by Doctors Without Borders (MSF) at the Maison des Métallos venue, either, although the organisers refused to cede to similar pressure from the Israeli embassy.