Meeting in Strasbourg on Monday, the Council backed the move not to publicly criticize the tiny country by 71 votes to 28.
The ninety nine members make up the pan-European watchdog that monitors its 45 members for European norms of democracy and human rights.
Liechtenstein came under heavy criticism in the Council of Europe after constitutional changes placed legislative, executive and judicial power firmly under the monarch's control.
Individual Council members denounced the extension of the royal family's powers as "a big step backwards" last March when the constitution was amended.
All powerful prince
But Liechtenstein's Prince Hans-Adam II threatened to pull out of the Council of Europe if it pressed to undo his changes.
The assembly's bureau also rejected monitoring Liechtenstein in a previous November vote.
It will however look into ways of conducting a dialogue with the Liechtenstein authorities to ensure that "constitutional practice is in conformity with the standards of the Council of Europe".
The prince's family has ruled the 160 square kilometre principality, nestled between Austria to the east and Switzerland to the west, for nearly 300 years.
Liechtenstein has been a member of the Council of Europe since 1978.