Unite-backed Karie Murphy has been reinstated to the party but said she was withdrawing from the race for the Falkirk seat for the sake of "reconciliation and unity".
The dispute had sparked a furious row between Ed Miliband and union leaders, with Unite firmly denying any wrongdoing.
A Labour spokesman said "key evidence" had been withdrawn from the inquiry, believed to relate to claims people were signed up as party members without their knowledge in a bid to stuff the constituency with Unite supporters.
"Karie Murphy and (constituency party chairman) Stevie Deans, who were suspended, will now be reinstated as they have not been guilty of any wrongdoing," he said.
"No organisation or individual has been found to have breached the rules as they stood at the time.
"The general secretary has determined that given these circumstances Scottish Labour should move to select its candidate for Falkirk.
"These steps will enable Labour in Falkirk without further delay to choose a candidate and prepare for the general election."
The pair were suspended and the Falkirk constituency party put into "special measures" after an internal report - not yet published - found concerns over the process of selecting a candidate for the 2015 general election.
The party referred the matter to the police and handed over documents but Police Scotland ruled in July that there were "insufficient grounds" for a criminal investigation.
It was the ensuing bitter public dispute between Mr Miliband and Unite general secretary Len McCluskey that pushed the Opposition leader to propose reforms to Labour's historic links with the trade unions.
Tom Watson - for whom Ms Murphy worked - quit as the party's general election co-ordinator at the height of the dispute.
In a statement released by Unite, Ms Murphy said she had been left "shocked and saddened" by the affair and had always acted in the interests of the party.
But she said her continued presence in the Falkirk contest would "detract" from the work of selecting a good candidate.
"Recently I have met with senior colleagues from both Unite and the Labour Party and have agreed that reconciliation and unity are paramount.
"It is therefore with great sadness that I must withdraw my name from any consideration to be the Labour Party candidate in Falkirk.
"As an activist of 25 years, I was honoured to be persuaded to stand as a local MP, but there is only one decision to be made in the interest of progression."
She went on: "Throughout the controversy surrounding what we consider to be the revitalisation work in Falkirk both Stevie Deans and myself have maintained that we have done nothing wrong, and that our union Unite has done nothing wrong.
"The media attention on Falkirk has centred on candidate selection and, whilst having MPs who represent the values of ordinary working people is very important, our objective of getting ordinary members actively involved in a vibrant local party has been forgotten in media coverage.
"Developments in Falkirk have left me shocked and saddened but I have acted throughout in what I believe was in the interest of the Party.
"I have been sustained during this difficult period by my union, but most importantly, by the members in Falkirk who deserve the highest representation and support. I believe that my continued presence in the Falkirk arena detracts from achieving that goal."
The Labour spokesman said: "At each step Labour's general secretary and NEC have acted quickly to protect the interests of the party.
"Since Labour began its internal process key evidence has been withdrawn and further evidence provided by individuals concerned."
The developments appear to draw a line under the Falkirk affair but Mr Miliband remains embroiled in difficult relations with the trade union movement - who he will address at the TUC annual conference on Tuesday.
The GMB has announced it will cut affiliation funds paid to Labour from £1.2 million to £150,000 in response to the proposed reforms.
Mr Miliband wants union members to opt in to joining Labour rather than being automatically affiliated, a decision which could cost the party millions of pounds.
Union officials believe the reform will weaken the historic link between Labour and the unions, and even threatens to sever it altogether.
Conservative Party chairman Grant Shapps said: "It's clearer than ever that Len McCluskey is calling the shots in the Labour Party.
"If Ed Miliband can't even stand up to his union paymasters, how can he stand up for hard working people?
"Weak Ed Miliband must now stop dithering, come clean and publish Labour's report into the Falkirk selection in full."