Santander was one of the companies most exposed to the scheme Madoff allegedly ran.
It revealed in December its investment fund Optimal had a $3bn exposure to the Madoff scheme.
A Spanish law firm said a day earlier the bank was being sued in the US by investors who say they lost money in a Madoff-linked fund.
The lawsuit claims Santander was negligent, saying there was a "plethora of red flags" that should have alerted the bank that Madoff was running an alleged pyramid scheme.
In a statement Santander said it would repay the money of its private bank clients.
Santander in a statement: "The group has taken this decision given the exceptional circumstances surrounding this case and based exclusively on commercial reasons, given the interest it has in maintaining its business relationship with these clients."
Santander added that its offer will cost $660m which will be absorbed in the bank's results for last year.
The bank has forecast a net profit of $13bn for 2008.
Meanwhile, Spain's economy is officially in recession after figures showed it had contracted sharply in the last two quarters of 2008.
Spanish economic output fell 1.1 per cent in the last three months of 2008 compared with the previous quarter, the Bank of Spain said.