Prosecutors decided to take no action against Gordon Matheson after concluding there was "insufficient evidence" of a crime.
Matheson admitted he had not lived up to his own standards following an alleged incident in a car near his house in Cathcart on Glasgow's southside in December.
Openly gay Matheson said the encounter exposed "an affair" with another man, and apologised to his long-term partner, Stephen Wallace, with whom he has a civil partnership. Last year Matheson said he would marry Wallace when legislation allows same-sex weddings.
Matheson's Holyrood prospects now appear far from rosy, with senior Labour figures claiming his behaviour is likely to prove too much for voters or the Labour selection process.
Party insiders say Matheson, 46, is eyeing the Labour candidacy in Glasgow Cathcart for 2016, a seat the SNP's James Dornan took from Labour in 2011 with a 1592-vote majority.
But being questioned by police about his behaviour in the area is a a terrible advertisement for a would-be candidate, some party members believe. He also has rivals.
Also thought to be interested in the seat for Labour are Sadie Docherty, Glasgow's Lord Provost, and Stephen Curran, who has reportedly given up on dislodging deputy SNP leader Nicola Sturgeon from neighbouring Glasgow Southside, where he stood in 2011.
An alternative target seat for Matheson, Glasgow Kelvin, which covers his council ward, is held by the SNP's Sandra White with a majority of just 882. But it means even stronger competition from Labour hopefuls.
One Labour MP described Matheson's actions as "f***ing insane" and hard to live down: "I know he says it's a personal matter, but if something's a private matter, you do it in private. He was doing it in public. It makes his position very difficult."
Another Labour source added: "Matheson's not bombproof, as he was six months ago [after Labour won the local election]. I don't necessarily think this is fatal. But it will affect his longer-term aspirations - The idea of him standing for parliament has now taken a big step back."
A source close to Matheson said he had appeared "distracted" and "not at his best" in recent days: "There has to be a question about judgment and leadership. It's not about [any alleged sexual activity], it's about lack of judgment and risk-taking. Doing something like that where your loved one might catch you? It's horrible, horrible."
But other Labour sources last night said while Matheson had been "stupid", his short-term prospects were solid, and there was no need for him to quit, meaning he stays the public face of Glasgow for the 2014 Commonwealth Games.
The SNP in Glasgow is also happy for Matheson to hang on, as a weakened leader may ultimately cause Labour more grief.
Also helping Matheson is the absence of immediate rivals for the leadership. Councillors Paul Rooney and Stephen Curran, who might have been expected to mount a challenge, are understood to be focused on becoming MSPs in 2016 instead.
Matheson was elected leader by his fellow Labour councillors in May 2010 after the resignation of Steven Purcell, whose breakdown exposed a history of drinking and cocaine use.
The city's Labour group is still deeply divided, but against expectation Matheson led Labour to victory in 2012's council elections, and was rewarded by Scottish Labour leader Johann Lamont with a place in her shadow cabinet.
The coming months are critical to Matheson, with the approach of the Glasgow Labour Annual General Meeting, when any challenge will appear.
One Labour councillor said: "The party is quite supportive. But we have the AGM in May. There were already issues about his credibility. This takes it further."
A council source said Matheson acknowledged the seriousness of his errors but was back at his desk on Friday. "He's focused on the job," the source said.