A lower court in June had ruled in favour of a lawsuit by activists that prosecutors should press on with charges against Suharto, who is accused of corruption during his 32-year rule.
The three non-government organisations had asked the court to reverse a decision by Abdul Rahman Saleh, the attorney-general, in May to drop the charges.
But an official said on Thursday the appeals court had upheld Saleh's ruling on the grounds of Suharto's poor health.
Yohannes Suhadi, a spokesman for the South Jakarta district court, which overturned the June ruling, said: "The panel of judges examining the case ruled that the decision to drop the Suharto case was legally valid.
"One of the considerations is that former president Suharto is suffering from non-fluent aphasia, which prevents him from communicating orally and in writing," he said.
Suhadi said activists wishing to challenge the ruling can file an appeal to the Supreme Court.
When the attorney-general made his decision, Suharto was in hospital undergoing a series of operations related to internal bleeding.
He has since returned home.
Suharto, 85, has had a variety of health problems and has been hospitalised several times since he lost power in 1998. Courts have ruled in the past that he was not fit to stand trial.
The charges relate to allegations of misuse of funds by seven charity groups once headed by Suharto. But his critics say the amounts involved are a small part of billions of dollars misspent or improperly funnelled to his family and associates during his rule. Suharto has denied any wrongdoing.
President Yudhoyono has put off
a decision on Suharto's legal fate
Susilo Bambang Yudhoyono, the president, said in May he had decided to hold off on a decision on Suharto to weigh every aspect of the case.
Any move by Yudhoyono to drop charges against the former ruler could be subject to legal challenge, experts and politicians say.
Supporters say Suharto's age, as well as his health, is reason to drop pursuit of the graft charges now, while opponents argue that no one should be above the law and that dropping the case would send a message that the country is not serious about rooting out corruption.