Ishmael Wadi, the director of public prosecutions, announced on state radio on Monday that the charges against Bakili Muluzi were being dropped.
Muluzi, who ruled the poor southern African country from 1994 to 2004, was held briefly for questioning on Thursday about allegations that he diverted millions of dollars in government funds into his own bank account and that of his party.
The arrest was seen as part of a broader anti-corruption drive started by Muluzi's successor, Bingu wa Mutharika, who has taken on members of Muluzi's inner circle since becoming president in 2004.
In a surprise move, wa Mutharika later on Thursday suspended the head of Malawi's Anti-Corruption Bureau, which had been leading the Muluzi investigation.
Wadi said the bureau had no one sufficiently senior to take over the case.
Political analysts say Muluzi, the chairman of the opposition United Democratic Front, remains one of Malawi's most powerful figures and is capable of upsetting wa Mutharika's drive to secure a better economic deal for the country.
Specifically, analysts say the party could use its voting block in parliament to delay passage of the budget - a key step toward securing a promised $2.9 billion package in debt relief from Western donors.